(Bloomberg) — For the first time in nearly a generation, fixed income is living up to its name.
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This, to some extent, is just the consequence of the jump in benchmark rates in the United States from 0% to over 5% in the space of two years.
But at a time when all of Wall Street seems obsessed with whether the Federal Reserve will actually cut interest rates this year — and when heated debates are erupting over whether U.S. 10-year bonds should yield , say, 4.5% or 4.65% – that’s easy. losing sight of an important fact: after being held hostage by zero-rate policies for nearly two decades, U.S. Treasuries are finally returning to their traditional role in the economy.
In other words, it is a source of income that investors can secure and rely on, year after year, for years to come, regardless of the returns situation at any given time.
The numbers tell the story. Last year, investors pocketed nearly $900 billion in annual interest on U.S. government debt, double the average for the previous decade. This figure is expected to rise as almost all Treasuries now yield 4% or more. As of mid-2020, none have done so. Due to higher interest rates, investors are also better protected against any rise in yields. Currently, rates would have to rise more than three-quarters of a percentage point over the next year before Treasuries start losing money, at least on paper.
Over the last decade, this margin of safety has sometimes practically disappeared(1).
“With the help of our friends at the Fed, they reinvested the earnings into fixed income,” said Anne Walsh, who oversees about $320 billion as chief investment officer at Guggenheim Partners Investment Management. “And fixed-income investors can enjoy the benefits of higher yield.” This is a good thing.”
Two recent economic trends have worked in their favor.
First, even though inflation is very close to the point where the Fed might consider cutting rates, progress toward its 2% goal has stalled lately. This has pushed back expectations for a rate cut at least towards the end of the year.
Second, and perhaps more importantly, it's simply that the economy continues to hum (despite some signs of cooling in the labor market), which suggests the Fed won't need to cut rates that much when it starts.
Fed Chairman Jerome Powell underscored this wait-and-see approach in remarks last week after the central bank held rates steady, while traders currently expect just two quarter-point rate cuts. here the end of the year. At the start of the year, they had evaluated as many as six. On Monday, two Fed officials supported Powell's view, saying they were still monitoring the trajectory of the economy.
“Nobody is worrying anymore about what could go wrong if the economy goes off the rails,” said Blake Gwinn, head of U.S. interest rate strategy at RBC Capital Markets. “And every month that goes by is another month without any outages.”
As a result, safe assets like Treasuries – from one-month Treasuries to 30-year bonds – now have something to offer everyone looking for income.
Money, money, money
In February, the Congressional Budget Office projected that interest and dividend payments to individuals would reach $327 billion this year — more than double the amount in the mid-2010s — and continue to rise each year over the next decade. come. In March alone, the Treasury Department paid about $89 billion in interest to debt holders, or about $2 million per minute.
It is no small irony that new revenue from Treasuries may itself play a role in keeping the “higher for longer” narrative intact. A small but growing number of people on Wall Street say that, along with soaring stock prices, the interest paid on Treasuries and other bond investments is creating a significant wealth effect among Americans, with the extra cash acting like checks stimulus supporting the surprisingly resilient economy. economy.
Of course, the appeal of holding U.S. government bonds is that they are not expected to generate losses, are less volatile than stocks, and will provide a fixed rate of return above inflation. There is no hiding the fact that the very reason Treasuries are once again in demand as a buy-and-hold option – after years of near-zero returns – is due to the latter's brutal losses. years in the face of galloping inflation and aggressive policy. rate increases to combat this scourge.
This reset, painful as it was, has now paved the way for higher future returns and a “more normal” fixed income market.
Investors reacted en masse. Money market funds — which invest in short-term securities like Treasury bills — saw their assets swell to a record $6.1 trillion last month. At the same time, bond funds have raked in $300 billion in 2023 and $191 billion so far this year, reversing outflows in 2022 that were the largest in recent memory, according to data from the 'EPFR. Direct sales of Treasury bills to individuals also surged.
In total, the amount of debt held by households and nonprofits has jumped 90% since the start of 2022 to a record $5.7 trillion, according to Fed statistics.
Dan Ivascyn, chief investment officer at Pacific Investment Management Co., says revising yields on high-quality debt securities of all kinds, from Treasuries to corporate bonds, will have broad implications for buyout firms, hedge fund managers and private credit companies. stores that raked in hundreds of billions of dollars when rates were at their lowest.
Back to the future
He also pointed out that bonds now represent “enormous value” compared to stocks. By one measure, known as the Fed Model, they are more attractive relative to U.S. stocks than at any time since 2002.(2)
“We're getting a lot more inquiries about fixed income than we have in the last 15 years,” Ivascyn said. Investors ask themselves, “Why am I making things so complicated when I can get 6, 7, 8% of the bonds?” So this opens up a whole new buyer base.
There is of course no certainty that this will continue. But there are strong reasons to believe that yields will not return to post-financial crisis levels, even after the Fed begins cutting rates. This means that fixed income will likely remain in high demand.
For starters, nagging concerns about inflation, fueled in part by trends such as the deglobalization of supply chains, will likely keep rates from falling too far as investors demand protection against the risk of their income being eaten away by the rising cost of living. After taking into account inflation, yields have now returned above 2%. The last time this happened sustainably was before the 2008 financial crisis.
Then there is the massive US deficit, which will almost certainly be financed by a relentless supply of new bonds. Not only will this likely keep yields high, but it will also provide a growing source of interest income for bond investors month after month.
“It feels like a return to the future — a little return to normal times,” said Matt Eagan, a fund manager at Loomis Sayles & Co., which oversees about $350 billion. “It’s a pretty significant turnaround.”
–With help from Ira F Jersey.
(Updates to add comments from Fed officials in 11th paragraph. A previous version of this story was corrected to show that the figure referred to yields in the fifth paragraph.)
(1) Estimate based on the duration of the Bloomberg Treasury Index, which includes securities across the maturity spectrum. Figures for individual titles vary.
(2) The Fed model is a valuation tool that compares the earnings yield of S&P 500 companies to the yield of 10-year Treasury bonds.
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