% Points of Interest

Moving the Goalposts


In a recent Chart of the Week we pointed out that the 2 Year Treasury yield recently exceeded the S&P 500’s dividend yield for the first time since the financial crisis. Although a 2 Year Treasury yield in the 2.40% range certainly isn’t high by pre-crisis standards, it’s still a good reminder of just how much the landscape for fixed income investors has improved.

Consider the following:

  • Bond yields have risen significantly. Current 1, 2, and 3 Year Treasuries are approximately 2.15%, 2.40%, and 2.50%, respectively. Just over 6 months ago, the 10 Year Treasury yield was lower than all these levels, touching 2.05%.

Going back a bit further, about 1.5 years ago (late summer 2016), the 10 Year Treasury offered bondholders a paltry 1.60%. This seemed a princely premium to what was available in the shorter maturities – not even the 3 Year Treasury reached so much as 1.00%. Forget the prospect of capital growth – levels like that were simply unacceptable for even capital-preservation purposes.

Clearly, we’ve come a long way. For the first time in nearly a decade, investors can reasonably hope to maintain their capital’s purchasing power (i.e. grow their principal at the rate of inflation) with short-term bonds.

  • At the same time, the yield curve has flattened considerably. All else equal, investors can typically find extra yield by buying longer maturity bonds; the tradeoff is that the longer the maturity, the more sensitive the bond’s price is to interest rate fluctuations. Given this relationship, rational investors must weigh the benefit of a longer maturity’s additional yield with the potential for larger price declines and volatility.

One simple way of measuring the premium you can get from “reaching” for yield is by examining the shape of the yield curve; a “steeper” slope, or upward-sloping yield curve, means a larger step-up in yield for purchasing a longer maturity bond. On the flip side, a “flatter” slope, or downward-sloping yield curve, translates into a smaller yield “reward” for accepting the same increase in price risk.

We’ve seen significant curve flattening over the past year:

Source: Bloomberg

What’s the upshot? As shown earlier, yields have risen considerably over the past 6 months. At the same time, the risk-reward tradeoff between buying shorter vs. longer maturity bonds has deteriorated. This means the relative incentives for staying in shorter maturities are more compelling than they’ve been in a long time.

Investors still receive more yield by reaching out longer – that’s typical of normal economic conditions and not likely to change anytime soon. But with rates and slopes where they are, you aren’t missing out on much by refusing to take the bait.

Simply put, the range of palatable choices for fixed income investors has materially increased in a short period of time. We think the conditions are poised for further improvement and continue to maintain a bias towards shorter-maturity bonds in most client accounts. We await the opportunity to rotate into longer-maturity paper when the risk-reward equation of reaching for yields becomes more favorable. In the meantime, shorter-maturity yields just keep getting better. Stay tuned.

Authored by Daniel Beniak

Treasury Partners is registered with HighTower Securities, LLC, member FINRA and SIPC, and with HighTower Advisors, LLC, a registered investment advisor with the SEC. Securities are offered through HighTower Securities, LLC; advisory services are offered through HighTower Advisors, LLC.

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