What the 10Year Treasury’s Dip Means for Bond Portfolios

Post on: 16 Март, 2015 No Comment

What the 10Year Treasury’s Dip Means for Bond Portfolios

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It was hard to miss the headlines earlier this week about the 10-year Treasury yield dipping below 2% Wednesday, hitting its lowest level in over a year.

And though the 10-year yield recovered somewhat Thursday as Treasury prices dropped, Wednesday’s dip below 2% came as a surprise. Many investors, me included, had been expecting a more consistently slow and steady rise in yields, as the U.S. economy continues to recover and the Federal Reserve (Fed)’s rate normalization nears.

So what caused the sharp drop? A number of market watchers attributed Wednesday’s 10-year Treasury yield move to fears about a global economic slowdown, heightened geopolitical unrest, growing worry over the Ebola health risk and uncertainty about Fed policy. However, while these factors certainly played a role, and especially contributed to stocks’ recent losses, I believe technical market factors, not fundamentals, were more to blame for Wednesday’s Treasury movement.

The extremity of the yield drop suggests it’s highly unlikely to have been caused by a wholesale reevaluation of fundamental economic conditions. Despite some weaker data releases Wednesday morning, U.S. economic growth is still in relatively good shape compared to the rest of the world. As such, in my opinion, the sharp decline in Treasury rates was largely the result of some large market players unwinding crowded trades in the Treasury futures markets, as they watched yields move differently from the expected road map.

As for what this all means for fixed income portfolios, there are a number of implications.

It’s clear that yields are likely in for a rocky ride as seasonal factors and technical unwinds of crowded positions play out in the weeks ahead, and as we get closer to a Fed rate hike, which should come sometime before mid-year 2015 .

But despite the recent risk-off rate rally, as we work through the recent duress and get into November and December, rates will likely drift higher again as the U.S. recovery continues and Fed tightening nears.

However, the rise should be moderate given ongoing geopolitical turmoil and low rates in Europe and Japan. In part, it’s the very low rates in places like Europe and Japan that have increased demand for long-term bonds in the United States, supporting their prices and helping to keep yields low.

Ultimately, I see the 10-year Treasury yield finishing 2014 around 2.65% to 2.75%, though I see it trending higher to 3% over the intermediate term. Against this backdrop, investors may want to consider five bond moves.

Favor longer-dated Treasuries. The 10-year Treasury yield still appears attractive relative to sovereign rates elsewhere in the world. In addition, longer-dated Treasuries also look more attractive than those with two- to five-year durations. which are likely to exhibit the most volatility and be most vulnerable to rising rates.

Go for high yield bonds. The 10-year Treasury yield’s recent move has high yield bonds looking more attractive on a relative basis. Earlier in the year, high yield levels sat at 5% vs. 2.5% for the 10-year Treasury. That relationship has changed to nearly 6.5% for high yield vs. 2% for the 10-year Treasury. As such, high yield bonds offer a better value, particularly as high yield defaults should remain muted for the time being.

Consider long-end municipal debt. While munis are no longer cheap on an absolute basis , they remain relatively attractive. especially long-end muni bonds. Plus, the sector looks compelling given improving issuer credit conditions and higher tax revenues.

Overweight mortgage-backed securities. Select commercial mortgage-backed securities and non-agency mortgages continue to look attractive given today’s low-rate environment .

Don’t forget total return-oriented and opportunistic strategies. Given the likelihood of more volatility ahead as rates normalize, investors should consider allocating at least a portion of their fixed income portfolios to balanced approaches, as well as to flexible, go-anywhere investing strategies that look for opportunities across a wide set of asset classes and global markets, adjusting duration and rate exposure as needed. Such investing approaches can potentially help investors mitigate interest rate risk and protect against market shocks.

For more on what this week’s market moves mean for portfolios, check out my colleague Russ Koesterich’s recent post on whether equities are entering a bear market .

Sources: BlackRock, Bloomberg.

Rick Rieder, Managing Director, is BlackRock’s Chief Investment Officer of Fundamental Fixed Income, is Co-head of Americas Fixed Income,  and is a regular contributor to The Blog. You can find more of his posts here.

This material represents an assessment of the market environment at a specific time and is not intended to be a forecast of future events or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice regarding the funds or any security in particular.

Fixed income risks include interest-rate and credit risk. Typically, when interest rates rise, there is a corresponding decline in bond values. Credit risk refers to the possibility that the bond issuer will not be able to make principal and interest payments. * Non-investment-grade debt securities (high-yield/junk bonds) may be subject to greater market fluctuations, risk of default or loss of income and principal than higher-rated securities. * There may be less information on the financial condition of municipal issuers than for public corporations. The market for municipal bonds may be less liquid than for taxable bonds. Some investors may be subject to federal or state income taxes or the Alternative Minimum Tax ( AMT ). * Mortgage-backed securities (MBS) and commercial mortgage-backed securities (CMBS) are subject to prepayment and extension risk and therefore react differently to changes in interest rates than other bonds. Small movements in interest rates may quickly and significantly reduce the value of certain mortgage-backed securities.

©2014 BlackRock, Inc. All rights reserved. iSHARES and BLACKROCK are registered trademarks of BlackRock, Inc. or its subsidiaries. All other marks are the property of their respective owners.

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