As we approach 2010, our outlook for fixed income markets in the coming year will, as usual, depend on the potential path of interest rates. One primary tool to assess the potential direction and magnitude of interest rate changes is evaluation of real, or inflation adjusted, yields. While the Fed has greater control of short-term yields, inflation and inflation expectations have a greater influence on intermediate and long-term bond yields. Of course, determining the potential path of interest rates has proven many an “expert” wrong over the years. However, using real yields can help determine a range of interest rate scenarios and the potential impact on bond market total returns as we did for our 2009 Outlook.
We use the real yield on the 10-year Treasury note since Treasuries form the backbone of the bond market and the 10-year is a good representation for both intermediate and long maturity bonds. The real 10-year Treasury yield is defined as the yield on the 10-year Treasury note minus annualized rate of core inflation as measured by the consumer price index (CPI). While overall CPI can also be used, the greater volatility of food and energy can lead to substantial short-term swings and makes core CPI a more reliable gauge. Using Friday’s closing 10-year yield of 3.5% and subtracting current annualized core CPI of 1.5% produces a real yield of 2.0%, slightly below the 10-year average of 2.3%.
The higher the real yield, the more attractive bond investments are, and the lower the real yield, the more expensive the market is. Similar to the price-to-earnings (PE) ratio for stocks, real yields indicate whether bonds are “cheap” or “expensive”. A high PE ratio is akin to a low real yield and vice versa. Historically, a high real yield has generally led to better bond market performance (table 1) compared to a lower real yield. It’s worth noting in the table below, the 12-month return following the October 2001 low was aided by the corporate scandals and returns following the September 2006 low were aided by the sub-prime crisis.
The current 2.0% real yield may seem low and by historical comparison it is. Over the years, the Fed has gained credibility as an inflation fighter and helped drive real yields lower [Chart 2]. As a result, bond investors have required less and less of a premium to protect against inflation and this has helped drive intermediate and long-term interest rates down. Many factors affect the real yield that bond investors require. For instance, the weaker economic growth is the lower the real yield investors require as weak economic growth implies lower inflation and therefore less need to protect against it. Conversely, the stronger economic growth is the higher real yield investors may require. The general level of inflation can impact the real yield (as Chart 2 demonstrates) and over coming years, heavy Treasury supply may also influence investors to demand a higher real yield.
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What Say the Fed?
The Fed still has substantial credibility with bond investors and coupled with low inflation forecasts the real yield demanded by bond investors will likely stay low. Core CPI is expected to fi nish 2010 near its current level of 1.5% according the average forecast of Primary Bond Dealers. Based on this we can approximate the level of the 10-year Treasury yield at the end of 2010. If economic growth turns out to be relatively weak then the bond market might require a 2.0% real yield, which produces a hypothetical 3.5% 10-year Treasury yield (2.0% real yield plus 1.5% core CPI consensus forecast). If economic growth is stronger than expected, or Treasury supply more difficult to handle, then the bond market might require a 2.5% or even a 3.0% real yield, producing a 10-year yield of 4.0% or 4.5%, respectively, again simply adding the inflation forecast and the real yield. Additionally, if the consensus inflation forecast proves too low then the 10-year yield might rise accordingly. However, the important conclusion to draw is that the expected low level of inflation will likely disappoint investors looking for sharply higher bond yields in 2010. Note in the example above, a 3.0% real yield produces a hypothetical 4.5% 10-year yield. The bond market has not witnessed a 3.0% real yield since December 2003 so a move to a 4.5% 10-year yield could arguably be viewed as a stretch as it would represent a substantial departure from recent history. A 5.0% 10-year yield, which implies a 3.5% inflation adjusted yield is certainly a stretch unless inflation forecasts are ramped higher or economic growth is much stronger than expected. Therefore, investors looking for 5% plus type Treasury yields will likely be disappointed.
Keepin' It Real
Real yield analysis has implications for the broader bond market since all bonds are priced in relationship to Treasuries. Given core CPI inflation forecasts of 1.5%, a 2.0% to 3.0% real yield produces a yield range of 3.5% to 4.5% yield on the 10-year Treasury, roughly unchanged to 1.0% higher than the current yield. Such an increase in yields implies a low, although not necessarily negative, total return for high quality bond investors in 2010. Real, or inflation adjusted, yields are a key tool for assessing bond market valuations as well as the potential direction and magnitude of interest rate changes. The real yield is affected by many factors including the level of inflation, economic growth, and supply and is therefore certainly subject to change. However, by considering a range of outcomes investors can approximate the potential path of interest rates and how it will impact bond market performance. The expected rise in interest rates will likely translate into lower returns but low inflation expectations suggest that investors looking for sharply higher yields in 2010 will likely be disappointed. We favor high yield bonds since we expect high-quality bond returns to be low going forward.
- This was prepared by LPL Financial. The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance reference is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly.
- Government bonds and Treasury Bills are guaranteed by the US government as to the timely payment of principal and interest and, if held to maturity, offer a fixed rate of return and fixed principal value. However, the value of funds shares is not guaranteed and will fluctuate.
- The market value of corporate bonds will fluctuate, and if the bond is sold prior to maturity, the investor’s yield may differ from the advertised yield.
- Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and are subject to availability and change in price.
- High yield/junk bonds are not investment grade securities, involve substantial risks and generally should be part of the diversified portfolio of sophisticated investors.