Even before last summer's big Treasury bond rally, there was buzz in the financial press about the question of whether we were in a bond "bubble." With yields having fallen even further since then--and even factoring in an uptick during the first quarter of 2012--there's still a palpable sense among market participants that something about Treasury bond yields just isn't right. Back in February, the CEO of BlackRock, one of the market's largest bond managers, famously told Bloomberg News that "investors should have 100% of investments in equities because of valuations and higher returns than bonds."
Much of the talk until recently has simply focused on how low Treasury yields have gone. They sounded low to many people when the 10-year note was at 3.5% in early 2011, and a majority of core bond-fund managers kept their funds' interest-rate sensitivity short of the Barclays U.S. Aggregate Bond Index over the course of the year. In the wake of the summer 2011 rally, though (and even after the first-quarter 2012 spike), the 10-year yield looks "really" low at 2.3%.
What does it mean, though, to say that yields are low? Well, one relatively simple way to view a bond's yield is as compensation for holding it over a set period of time. The idea is that one can theoretically deconstruct that yield into compensation of different types depending on the kind of risk an investor is taking on. At a high level, many investors think about it as a split between the amount necessary to compensate for inflation and then everything else grouped together as the so-called real yield. For a typical municipal bond, for example, one might expect to be compensated for the risks of inflation plus various different amounts for risks associated with liquidity, credit quality, call features, and the term of the bond. Having a framework around which to understand how much bonds of different kinds ought to compensate investors is a crucial task for any active bond-fund manager. Each of those risk components may deserve to be larger or smaller at various times, and it is a manager's fundamental task to judge those levels and to either buy or sell bonds depending on whether they're providing enough value.
In some ways it's an even simpler exercise when looking at Treasury bonds because they're typically very liquid, they don't carry any embedded options, and, whether one agrees or not, they are generally viewed as free of credit risk. Yet, investors still demand to be compensated for the risks of buying Treasury bonds beyond that of inflation, at least based on the length of time one is effectively loaning money to Uncle Sam (if not a little extra to compensate for the risk that one's inflation expectations turn out to be wrong). Under normal circumstances, one can get an estimate of how the two components of compensation--inflation and real yield--break down by comparing a Treasury bond with a similar maturity Treasury Inflation-Protected Security. Because the inflation component of a TIPS bond's return is built into an adjustment of its principal value, the income it generates is essentially its real yield. By taking the yield of the regular Treasury bond and subtracting the real yield of a comparable TIPS issue, you're left with a rough approximation of the market's (annual) estimate for inflation over the term of the bonds. A few years ago, the calculation might have reflected a Treasury bond with a 5% yield, a TIPS issue with a 2.5% yield, and implied inflation level of 2.5%.
Today is a much different story. There are several reasons for it, not least of which is that the Federal Reserve is working hard to press down Treasury yields and coax investors into taking on more risk and effectively lending out more money to juice the economy. Whatever the cause, however, the 10-year Treasury note carries a yield just under 2.3%, but the yield for the closest TIPS issue is actually slightly negative. There's a lot of information baked into those numbers, but aside from what it says about inflation expectations, it tells you that buyers of regular Treasury bonds shouldn't expect any real yield. In fact, because the TIPS yield is negative, it suggests that buyers of regular Treasury bonds should actually expect to lose some of their investment to inflation over the term of their bonds.
That's a pretty remarkable statement from the market, and one that has informed the decisions of many fund managers who worry about yields rising from their current levels and who have treaded lightly in the Treasury market over the past year, in particular. Morningstar data suggest that more than 90% of funds in the intermediate-term bond category held fewer Treasuries than the Barclays U.S. Aggregate Bond Index, for example, and that more than 60% have been carrying durations shorter than that of the benchmark. We addressed the broader issue of core managers investing away from that index in a recent column, but their low Treasury allocations and interest-rate decisions were brought into particularly sharp relief in 2011 as Treasuries rallied and more than 88% of funds in the intermediate-term bond category underperformed the Treasury-heavy index.
Managers with whom Morningstar analysts speak have expressed their U.S. inflation expectations for the next several years across a range, but they, too, tend to cluster in the 2%-3% bracket, as the Treasury and TIPS markets are essentially predicting. The ultimate outcome of that question is what's arguably most crucial to the calculus of Treasury-bond values today. It's one thing to grudgingly accept a real yield of 1% when you think it should really be 1.5% or 2%. It's wholly another to accept a yield that you feel pretty certain is going to evaporate (in terms of purchasing power) over the life of the bond you're considering.
