A lot of ink has been spilled recently asking why bond yields have declined this year, as well as explaining why bond yields are bound to begin rising. The one question that hasn’t been asked is: Why does everyone believe bond yields have to head significantly higher?
At the start of 2014, everyone “knew” that bond yields were headed higher, but the year hasn’t played out that way. The yield on the benchmark 10-year Treasury is currently trading above 2.50%, but just last week it threatened to dip below 2.40%. This is a substantial decline from its year-ending 3.04%. Earning 2.5% or so for the next 10 years doesn’t sound all that good on its own, at least not to my ears. So what’s driving demand?
When 2.5% Bond Yields Are Sumptuous
Depending on your objectives and alternatives, the 2.5% yield on the 10-year U.S. Treasury actually looks pretty darn good … particularly when you compare it to other top-ranked sovereigns around the globe.
The chart below plots a number of 10-year sovereign bond yields with those from developed markets in dark blue, emerging markets in light blue and the U.S. in black. Note that the 10-year Treasury yields more than bonds from many strong developed-market economies including Germany, Japan, France and Canada. Even bonds from previously troubled European countries like Spain and Italy now yield less than 3%, so while you may pick up a bit more yield there, that extra yield comes with a heaping dose of risk. Even the emerging markets don’t offer great advantages, with several countries’ bonds sporting yields below 4%.
Add in the fact that the U.S. Treasury market is the deepest and most liquid of any securities market in the world, as well as their being the flight-to-safety asset of choice, and a yield of 2.5% suddenly doesn’t look half-bad — particularly if you have to buy bonds. And there are plenty of people who have to buy bonds: mutual fund and pension managers to name a couple.
But aren’t rates poised to rocket higher as we enter a new bear market for bonds?
Looking to history as a guide, regular auctions began in the early ‘60s and the chart below is the standard view of the 10-year Treasury’s yield which most bond investors are familiar with. In essence, it appears that bond yields have either been on one grand sweep higher (a bear market for bonds) or a long ratcheting down (a bull market for bonds). But isn’t there a third option — of a sideways, rangebound environment?
Well, if we step back and include just one more decade of data, you can see that there was a roughly decade-long stretch, from about 1955 to 1965, when yields were range-bound around 4%.
And if we extend our view even further, as the chart tracking yields back to 1790 does, you’ll note that there are plenty of rangebound interest-rate periods. Putting aside the debate about whether more than two centuries of data is entirely relevant given the different economic and monetary systems encompassed by it, it is still fairly plain that there have indeed been long stretches when interest rates moved sideways. And consider that there was an almost 40-year period from the mid-1920s to the mid-1960s when the 10-year Treasury yield seemed permanently stuck below 4%.
It has been five years or so since the 10-year Treasury’s yield dropped below 4%. Could we be five years into yet another rangebound market? It’s possible.
Or maybe the past five months have just been a pause in a slow grind higher in rates. We won’t know until it’s over, but just because rates are low today doesn’t mean a sharp, sustained move higher and a steep decline in bond prices will come tomorrow.
Senior Editor Dan Wiener and Editor/Research Director Jeffrey DeMaso publish The Independent Adviser for Vanguard Investors, a monthly newsletter that keeps abreast of recent developments at Vanguard, and the annual FFSA Independent Guide to the Vanguard Funds.