This article is part of Morningstar's "Perspectives" series, written by third-party contributors.
The bond market bear has started to show its teeth, but does this mean that investors are wise to really ignore a $100 trillion market?
After more than a 35-year bull market in bonds, the surge in US Treasury yields earlier this year and again in April has put some investors on edge. The long awaiting rise in yields has finally arrived, with the 10-year yield moving above 3% this week. The initial surge in yields was bond markets re-pricing to reflect a stronger growth outlook for the year ahead and a faster pace of tightening from the US Federal Reserve. April has seen another leg up in bond yields in April, this time driven by higher commodity prices and rising inflation expectations.
Since of course bond yields move inversely with prices, any significant hike in Treasury yields results in capital losses. The longer the duration of the bonds, the more interest rate sensitive they are.
All this highlights the clear need to be mindful of duration risk and potential capital losses on government bonds. However, investors shouldn’t necessarily shun the broader fixed income market, especially in an environment where the near-term threat of a recession remains low – and underlying company fundamentals are robust.
Economic conditions in the US and elsewhere in the world look robust for the coming 12 months, meaning that government bond yields should continue to march higher as inflation firms and the Fed continues to tighten monetary policy. But it also means that corporate balance sheets will be sturdy and default rates low.
Rising Yields Are a Positive Sign
All this said, government bond yields on a sustained path to higher levels is arguably a positive sign for the global economy. A modest 25 basis point increase in the US interest rates each quarter this year is completely palatable to markets. We would expect this pace of rate increases to push the US 10-year Treasury yield to between 3 – 3.5% by year end. To be greatly higher than this, a more sustained increase in inflation would be needed.
Investors should also bear in mind that 2018 is still a year of net bond buying by some central banks: the continued purchases by the European Central Bank and the Bank of Japan more than offsets the $50bn a month in monetary tightening from the Fed and this persistent level of demand will act to cap just how far bonds yields can rise.
The current macro and micro environment is one in which a broad, diversified allocation to different segments of the credit market should deliver single digit returns for investors. This may not sound very exciting, but bonds aren’t meant to be.
A cautious outlook on government bonds and duration is certainly warranted, but investors shouldn’t abandon the fixed income market altogether. We believe that even as yields on government bonds rise to 3%, and a bit above, this really reflects the continued reflation and growth in the economy. This view is not without risks and a sharp move higher in yields would create market ructions.
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