With the 10-year U.S. Treasury (UST) yield stuck below 0.7%, many investors are asking if there is any reason to invest in government bonds given the lack of income and risk if yields start to rise. However, long duration government bonds still have a role to play in portfolio construction even with these risks, and the support from central bank purchases should not be overlooked. For income seekers, investors can find better opportunities in high quality corporate credits, agency mortgage-backed securities (MBS) and selected U.S. dollar-denominated emerging market fixed income.
First, the Federal Reserve’s (Fed’s) monetary policy continues to place a firm ceiling on UST yields. The U.S. economy is still struggling through the damage from the COVID-19 pandemic. While the U.S. and Europe are slowly reopening, the experience from Asia suggests that this will be a gradual process, as governments will want to prevent a second wave of outbreak from taking place. Hence, the Fed is expected to keep policy rates close to zero and its asset purchase program running to keep borrowing costs low. Since early March, the Fed has already added almost USD 2trillion worth of government bonds and agency MBS to its balance sheet. The pace of asset purchases may be slow, but the direction is likely to remain given the expected rise in issuance to fund government spending.
That said, we think the Fed’s willingness to support economic activity via negative interest rate policy (NIRP) is very low. A number of Federal Open Market Committee members, including Fed Chairman Jerome Powell, expressed concern about the effectiveness of NIRP. Moreover, the Fed has already implemented a number of measures to push liquidity to the business sector, such as buying corporate bonds directly from primary and secondary markets.
Second, inflationary pressures will be contained, at least for the next 12-24 months, given the pandemic’s impact on global demand. The surge in unemployment rate around the world is a useful indicator of such spare capacity. While many unemployed workers consider themselves to be out of a job only temporarily and should be re-employed once the economy is back on track, the duration of this recession introduces some uncertainty to this optimism.
Third, geopolitical tensions between the U.S. and China are escalating once again. Due to the outbreak, China has not met its obligations in the January “Phase One” agreement to purchase U.S. agricultural products. Washington and Beijing are also locking horns over the handling of the COVID-19 pandemic. A return of tariff or other protectionist measures between the two sides ahead of the U.S. presidential elections in November could hurt risk sentiment, especially in equities where valuations are rich. Government bonds would provide some stability to portfolios in case of another round of risk aversion.
EXHIBIT 1: THE FED’S LARGE SCALE ASSET PURCHASES OVER THE PAST TWO MONTHS
For investors looking to generate income, we still see a portfolio that includes investment-grade corporate bonds and asset backed securities as a better option given the explicit support by the Fed and other central banks. The hunt for yield and income would also prompt investors to look into high quality, U.S. dollar-denominated emerging market fixed income, especially oil importers with low levels of government debt. Asian fixed income fits these criteria.
However, U.S. long duration government bonds still have a role to play in portfolio construction to hedge against downside risks to growth. The Fed seems determined to anchor UST yields despite potential aggressive issuance to fund its fiscal deficit. This would also address the liquidity challenges facing the Treasury market back in early March, which had led to a temporary breakdown in the negative correlation between equities and government bonds. Meanwhile, uncertainties surrounding the recovery from the pandemic, as well as additional risks from the U.S.-China trade tension re-escalating, could trigger a fresh round of risk aversion.