WE EXPECT INTEREST rates to remain at historically low levels, but the direction may be higher over the rest of 2020. Our year-end base-case forecast for the 10-year US Treaury yield is 1–1.5%, which would be the lowest level to end a year on record, if realized.
Rising Treasury yields contribute to bond prices falling, which can be offset by credit spreads tightening and the interest income that most bonds provide. With the credit spread for the Bloomberg Barclays US Aggregate Bond Index already near the average for the last cycle, and interest income at historically low levels [Figure 06], we would expect the index’s returns to be near flat over the rest of 2020 with some risk of losses; however, it would take a move above our target range to
erase gains from the first half of the year.
Several factors limit the likelihood of bond yields rising significantly beyond our target range—even in the case of a more robust V-shaped recovery. Short-term Treasury yields will be well anchored by the Fed. Intermediate- to longterm yields may be pushed higher by improving growth, but inflationary pressures may be limited by slack in the labor market until the economy recovers more fully. Demand for Treasuries by international investors may also help to cap rate moves, asUS yields continue to look attractive relative to other major developed market issuers like Germany and Japan.
THE FEDERAL RESERVE
Persistently low inflation during the last expansion should minimize any Fed concerns that it needs to raise rates preemptively to keep inflation under control.
Consistent with its messaging, we expect the Fed to remain accommodative for some time, and raising rates probably won’t be on the table until after it ends its
bond purchase program (known as quantitative easing). The Fed did not start raising rates in the last economic cycle until more than a year after its final round of
bond purchases.
The Fed also has discussed the possibility of instituting some form of yield curve control to help support the economy. If this were to happen, the Fed would set a
target cap for rates at maturities possibly as long as five years and buy enough Treasuries to keep rates below that threshold. Such a move would further help
anchor rates for longer maturity bonds. For now, even the possibility of such a program has helped to keep rates lower at the shorter end of the curve.
BEAR CASE
In that case, the current 10-year Treasury yield of 0.65% (as of June 30, 2020) may be likely to fall at least below 0.5% and could even move toward zero. If that were to happen, Treasuries most likely would see further gains, supporting the broad Bloomberg Barclays US Aggregate Bond Index and helping it build on its positive return in the first half of 2020. While this is not our base-case scenario, it does highlight why suitable investors may consider the potential diversifying benefit bonds.
We would recommend that suitable investors consider positioning portfolios with below benchmark interest-rate sensitivity and near benchmark credit quality. We favor mortgage-backed securities (MBS) for their combination of interest income and limited rate sensitivity. We are neutral on investment-grade corporate bonds with valuations only slightly attractive and leverage increasing, but we still see incremental value for corporate bonds over Treasuries.
We continue to prefer stocks to the credit-sensitive bond sectors. Nevertheless, for those long-term investors seeking income, the credit-sensitive sectors may have a role to play in a well diversified portfolio. Among those sectors, we would favor a mix of dollar denominated emerging market debt and high-yield bonds, with an underweight in equities to potentially help offset the added risk. We believe emerging market debt may likely benefit from the broadly supportive monetary policy environment, and valuations for high yield are still attractive, although the asset class leas away from some of the faster-growing sectors.
Municipal bonds yield still look attractive relative to Treasuries for tax sensitive investors.
We maintain a bias toward quality and are more cautious on high yield.