Fixed income market data indicate that money continues to pour into the bond market. This in spite of the punditry’s warning that yields will rise further, sending bond prices lower. Some read this flow of capital into bonds as a sign of fear among investors. Today’s Wall Street Journal features an article reporting that it is skepticism about the equity market that is fueling bond buying. The article states:
“Investors are buying record volumes of new bonds, signaling that many remain skeptical about the prospects for faster economic growth and are reluctant to move on from a strategy that has worked for years.”
More than 90% of my audience consists of financial advisors, with an average age in the mid-50s. I would ask this large segment of my audience: Why do your clients own bonds, out of a general fear of the equity markets or are bond holdings more demographic in nature?
I will venture it is the latter. An increasing portion of the investible capital in this country (and in Europe and Japan, as well) is owned by older investors (over 55 or over 60). Is there a measure of fear among older investors? Probably, but it is because they are in the distribution phase of their lives. They cannot afford a severe realized and potentially permanent hit to their principal. Yes, they will maintain some, even significant, exposure to equities, but bonds are likely to comprise a greater portion of their portfolios than when they were younger and in the accumulation part of their lives.
This seems very obvious, frustratingly so, but financial journalists and some investment strategists do not seem to understand this. When it comes to strategists, either they don’t want to understand this or acknowledging that the demand for bonds is probably far more structural than it is cyclical could be detrimental to their careers. A few months back, I opined that rather than figure out where the markets and/or the economy are going and reporting it to clients of respective firms, many strategists are now tasked with deriving a plausible scenario which could result in a firm’s preferred outcome. It truly does not take a PhD in economics to figure out what is going on in the markets, where capital allocation is concerned.
Meanwhile, also for demographic reasons, pensions are devouring nearly any supply of investment grade bonds they can find. U.S. Treasuries have experienced very robust demand from indirect bidders, which include pensions, for several years. Demand has increased during the past year and remains very strong. Pensions have also set their sights on corporate bonds. As the average age of pension participants increases, the larger the portion of fixed income assets in portfolios tends to become.
As with individuals, pensions are challenged with not only growing the value of portfolios, but, perhaps more importantly, they need to generate income and protect principal. Thus, liability-matching actuarial strategies are often used. This involves owing bonds with maturities matched to the expected needs of the pension. Based on everything I can see, the strong demand for bonds is based more on fundamentals rather than fear.
Another perplexing occurrence is the flattening of the yield curve, after Fed officials commented that it could begin reducing the size of its balance sheet. Missed by some is that fact that shrinking the Fed balance sheet, like tapering, is anti-inflationary. Except for a potential knee-jerk selloff, long-dated UST yields probably don’t have far to run. This is what happened during the taper tantrum and ahead of the Fed’s actual tapering of asset purchases. Long-term rates spiked twice in 2013, with the 10-year UST note touching 3.00% in September and December of that year. However, as tapering was tightening, at least in my opinion, long rates soon trended lower and the yield curve began to flatten anew. By the end of 2014, the benchmark 2-year to 10-year UST curve was as flat as it was before the Fed began to talk taper in May 2013.
Benchmark 2-year to 10-year UST curve, Jan. 2013 through Dec. 2014 , higher=steeper(Bloomberg):
Some of the flattening was helped by falling commodities prices, particularly oil and natural gas, in the summer of 2014, but the flattening was already well underway, by then.
Something else we must consider today is; since long UST yields bottomed and the yield curve became the flattest it has been in several years, last summer, long UST yields have risen and the yield curve has steeped considerably.
Benchmark 2-year to 10-year UST curve, since January 2016, higher=steeper (Bloomberg):
I see this as the bond market coming back to earth. Although I doubt that we see the curve becoming as flat as it was during the depths of last July and August, it could move below 100 basis points, from the 2-year UST yield to the 10-year UST yield. However, the curve could flatten at yields which are somewhat higher than we see today. There could also be a period of curve steepening, if the Fed temporarily pauses raising the Fed Funds rate to focus on balance sheet reduction. I would view any resulting curve steepening to be temporary and could represent a buying opportunity for investors needing to add duration to portfolios.
About Thomas Byrne
Thomas Byrne brings nearly 30 years of financial services experience to Wealth Strategies & Management LLC. He served as Director of Taxable Fixed Income for Citigroup, Inc. and predecessor firms in New York, NY. During the course of his long fixed income career, Mr. Byrne was responsible for trading preferred stock, corporate bonds, mortgage backed securities, government debt, international debt and convertible bonds. Mr. Byrne was also responsible for marketing, sales, strategy and market commentary within the taxable fixed income markets.