Interest rates are rising: should investors be concerned about bond yields?
The US 10-year bond yield has risen to almost 3%, triggering some armageddon-style headlines. Are investors actually looking at the wrong number?
Alongside bank rates, the most keenly watched borrowing rate is the 10-year government bond yield, which has been attracting a lot of attention since it approached 3% back in February.
Medium-term bonds are a good indicator of the market’s expectations of economic health. If yields fall, the market sees deflationary pressure and potentially difficult times ahead. When they rise it is usually a sign of economic confidence. If yields rise too fast it may be a sign that inflation is not under control and interest rates may have to rise faster than expected. With this in mind, central bankers around the world face a delicate balancing act in pursuing a ‘Goldilocks’ economy; neither too hot, nor too cold.
To assess whether the recent yield rises should be cause for concern, we can look at the absolute level of yields and the pace at which they have risen.
US 10-year government bond yield
Absolute level of bond yields
By historical standards, the absolute level of yields is still low. When the US 10-year yield fell to 1.4% after the UK’s Brexit referendum, a lost decade of ‘Japanification’ and deflation was the topic of the day. As it rose to 3%, commentators questioned whether the US Federal Reserve (Fed) has lost control of inflation. The reality is somewhat less exciting – the US economy is growing at around 2.3% year-on-year in real terms, while the core inflation rate is below 2%. This growth is fast enough to allow for some interest rate normalisation, while allowing inflation to slowly erode the government debt that piled up after the global recession.
Nevertheless, there has been a rise in corporate debt over the past decade, a substantial amount of which has been issued to finance share buy-backs, which, assisted by President Donald Trump’s tax cuts, Goldman Sachs expects to rise by 23% to $650 billion in 2018. Rising bond yields are a threat to business profitability, though corporates have had a very long time to prepare for this, as illustrated by the 11-year average maturity of the US corporate bond index. Indeed it was just a couple of years ago that some European companies were able to issue debt on a negative yield. Effectively being paid for the privilege of issuing debt.
It’s not just US yields which are increasing; yields across the globe are rising, and in the developed economies they do so more or less in lockstep with each other. For example, since 1990, the correlation between rolling 12-month UK and US 10-year yield rises has been 0.79, and in the past five years it has been 0.92. In short, when yields rise in the US they are very likely to do so in Britain.
12-month yield changes for the UK and US 10-year government bond
Rate of change in yields
Bond yields ebb and flow with the stories of the day, but the pace of change in yields arguably matters more than the headline level of the yield. The faster the yield changes, the more of a surprise it is to market participants, and thus more of an impact it will have on the pricing of investment markets.
The next chart illustrates how the rolling 12-month returns for 10-year US treasuries have changed since 1991. The dotted lines show standard deviations: assuming a normal distribution, we would expect 68% of yield changes to be within the green one standard deviation bands, and 95% of returns to be within the blue two standard deviation bands. Looking at the chart, this is quite a good fit. The big yield shock of 1994, when the Fed surprised the market by raising rates, was a two standard deviation event; these should happen once in every 20 or so years.
12-month yield changes vs. standard deviation
This puts the recent rise in bond yields into perspective – we have seen a very normal and controlled move that does not stand out at all on a historic basis. The past 12 months has seen yields rise by 0.47%, a move that is well within the one standard deviation boundary. The 10-year bond yield may well rise over 3% in the coming weeks, but we are some way from seeing the sorts of move that would cause panic in the markets.
As a rule of thumb, what size yield move might you call normal? If you accept that previous history could have some bearing on the future, 73% of 1-year yield changes since 1991 have been within plus or minus 1.0%. The hardest part for the fixed income strategist is predicting the direction of change, while the portfolio manager needs to take into account the correlation of fixed income returns with other asset classes. That will be the subject of a later article.