Will long-dated bonds protect me if volatility rises in 2019?Contributor Alex Dryden
U.S fixed income has had a tough 2018, with the U.S Aggregate down 1% year-to-date and set for only its fourth negative calendar year return since 1980. While core fixed income has experienced some pain this year, investors are wondering whether the back-end of the curve may begin to offer some protection in the face of greater volatility. In order to answer this question we need to consider the term premium.
What is the term premium? It is the additional yield an investor requires for locking up their money in a long-term bond instead of a series of shorter-term bonds. The higher the level of term premium the more uncertain investors are about the pathway for inflation and interest rates. However, as shown in the chart below, the term premium is currently in negative territory as investors are not particularly concerned about an overheating economy. This confidence has seen volatility in fixed income, measured by the MOVE index, fall to some of its lowest levels on record.
Looking into 2019 however, we believe that volatility in fixed income will begin to rise as the Federal Reserve continues to raise interest rates and global central banks continue curtailing asset purchase programs. This should result in investors demanding greater compensation for holding long-dated bonds, pushing bond yields higher on the back of a rising term premium. In short, investors are still unlikely to receive adequate compensation for the risks they are taking on in long-duration assets, and should therefore maintain a focus on short duration heading into 2019.
Interest rate volatility has been a major driver of the fall in the term premium
Merrill Lynch MOVE index, 10-year term premium (ACM), %
Source: Merrill Lynch, Federal Reserve Bank of New York, J.P. Morgan Asset Management.