May you live in interesting times…a saying of questionable origins that seems particularly fitting today as we navigate an unprecedented fixed income landscape. The U.S. yield curve is at its flattest level since 2007 and it has been deeply inverted at the front end since mid-May. The 10-year Treasury note has fallen to as low as 1.53 and is below the fed funds rate. Meanwhile, 30-year Treasurys are at record lows and currently yield less than 3-month Libor. The entire German yield curve out to 30 years is negative and in Switzerland, it is negative out to 50 years. There is a $16 trillion pile of negative yielding debt around the world and global central banks are officially trying to out-dove each other as one after next slashes interest rates in a race to the bottom. Against this backdrop, what is an investor to do?! Indeed, these are interesting times.
The precipitous plunge in yields and the velocity of this downdraft has been nothing short of breathtaking. Perhaps more troubling is the recent inversion of the spread between 2-year and 10-year Treasurys, which is often seen as a more traditional indicator of a coming recession. We are very respectful of this view, but it is also important to note that it is unclear if inversions mean the same thing now as they did a decade ago with yields so low. Additionally, inversions themselves do not cause recessions. The causes of recessions are in fact not well understood, even after we have experienced them, which is why economists have always been so bad at predicting them. Nevertheless, they never stop trying. We will be watching the yield curve closely in the coming months, mindful of the warning it is flashing, as well as credit spreads more broadly. The current combination of global economic headwinds is certainly conjuring up a general fear in many markets. Some good news to keep in mind in the face of the growing anxiety is that U.S. macroeconomic data remains non-recessionary and the domestic consumer in healthy shape and not highly vulnerable as household leverage was back to 1990s levels.
So what does investing in a negative rate environment mean? In truth, it is impossible to know exactly as these are new conditions that have emerged in the global economy and fixed income markets – in part a response to the ubiquitous uncertainty brought on by trade tensions, global growth concerns, U.S. recession fears and geopolitical flashpoints, in part a legacy of a decade of quantitative easing. However, we can see some clear implications here – for one, as many parts of the world have become uninvestable given yields among other characteristics, money will continue to flow into U.S. dollar assets and support U.S. credit in particular. Second, investors will have to drastically readjust their return expectations and become willing to accept more volatility in the traditional fixed income and equity portions of their portfolios. Finally, yield-chasing, speculative behavior will increase, likely resulting in higher risk in those portfolios. We are already seeing this play out in various parts of the credit markets. As an example, despite its growing political troubles, Italy raised a EUR3bn, 48-year bond. They had over $20bn in orders. And the price of the Austrian 100-year bond has soared to an eye watering 186% of par.
We question why an investor would purchase down-in-quality traditional fixed income with duration exposure in the present environment when not being compensated for the associated risks. That century Austrian bond has a yield of less than 1.00% while in the U.S., the term premium is nonexistent out to 20 years. In the meantime, the front end of the curve looks inexpensive on a valuations basis and especially attractive as it mitigates duration exposure that does not pay you anything currently. Avoiding credit risk altogether is not an answer. Investors can remain invested in credit throughout the cycle. However, we argue that defensive positioning remains the only option in the face of this pricing and fundamental environment. As such, there has never been a more compelling argument for owning front end/short duration loans yielding ~6%, while moving up in quality and seniority and picking up substantial income along the way.