In an investment environment where bond yields are frequently described with the words “all-time lows” and “record lows,” traditional bond valuations can help frame the yield discussion. A review of inflation-adjusted bond yields helps put some context around the decline in the 10-year Treasury yield to within striking distance of the all-time low set on July 24, 2012, at 1.39%. As of midday trading today (June 22, 2016), the 10-year Treasury yield is 1.70%—not far from the 1.57% low registered exactly a week ago, which also coincided with the 10-year German government bond yield dipping into negative territory for the first time ever. The extraordinary bond yield environment saga is indeed global.
It is no coincidence that the inflation-adjusted, or real, 10-year Treasury yield reversed course at a level that marked the halt of prior yield declines (see the chart below). The lower the real yield, the more expensive bonds are, and vice versa. When real yields are high, bonds offer more protection against future inflation and are more attractive from an investment standpoint, and vice versa. In February of this year, a similar situation occurred and bond yields moved higher after essentially matching the 2012 low in real yields. High-quality bonds have witnessed modest profit taking over the past few days in response to reaching the historical high-water mark with regards to valuations (low real yields), but it does not necessarily signal a sell-off is forthcoming—bonds can simply remain expensive.
As expensive as Treasuries are, they remain more attractively valued compared to their overseas counterparts in Germany and Japan, where real yields are deeper into negative territory at -1.2% and -0.8%, respectively. Only Great Britain’s 10-year has a higher real yield among high-quality developed country government bonds, in part due to the uncertainty surrounding the Brexit vote. Finally, real yields are not subject to long-term historical averages, which can act as a center of gravity, similar to yield spreads, a key valuation metric for non-government bonds. A host of factors, including demographics, central bank policy, and long-term growth prospects (just to name a few), impact real yields—with academics still debating the ideal fair value level.
In short, today’s bond valuations are expensive, but Treasuries remain among the best houses on a bad block. Near record low real yields signal caution but do not necessarily auger a quick reversal to higher yields and more attractive bond values. Unfortunately, investors must continue to grin and bear it. We continue to use mortgage-backed securities in combination with investment-grade corporate bonds to navigate the challenging environment for high-quality bonds.
Past performance is no guarantee of future results.
The economic forecasts set forth in the presentation may not develop as predicted.
The opinions voiced in this material are for general information only and are not intended to provide or be construed as providing specific investment advice or recommendations for any individual security.
Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values and yields will decline as interest rates rise, and bonds are subject to availability and change in price.
High-yield/junk bonds (grade BB or below) are not investment grade securities, and are subject to higher interest rate, credit, and liquidity risks than those graded BBB and above. They generally should be part of a diversified portfolio for sophisticated investors.
International debt securities involves special additional risks. These risks include, but are not limited to, currency risk, geopolitical and regulatory risk, and risk associated with varying settlement standards. These risks are often heightened for investments in emerging markets.
The Consumer Price Index (CPI) is a measure of the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services, and is a commonly used measure of inflation.
This research material has been prepared by LPL Financial LLC.
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