Hey, can you do me a huge favor? Can you borrow $100,000 from me for 10 years, and in 10 years you can give me less money back? Pretty please! Do we have a deal? This proposal sounds ridiculous and goes against all logic, but bond land is a funny place nowadays. Interest rates have fallen dramatically since late 2018 as the Fed reversed its hawkish interest rate outlook and as global banks around the world adopted accommodative policies to stimulate the global economy. The large interest rate declines have dramatically impacted not only your fixed income securities, but also have and will likely continue to affect stock valuations, corporate behavior, and government spending.
In the United States, the 10-year Treasury Bond yields less than 1.5% and the 30-year Treasury Bond provides less than 2.0%, a new all-time low. To put this into context, at the end of 2018, the 10-year and 30-year Treasury yielded 2.68% and 3.01%, respectively. These low interest rates are coinciding with very tight credit spreads resulting in low returns on corporate bonds and preferreds. How low? The average investment grade bond yield is the lowest in history at around 2.60%. The average high yield bond yields just over 5%, but this yield is inflated by very low-rated securities that many investors would find too risky. While these yields may sound depressed, the yields on bonds in many other developed countries are significantly lower, and in many cases, negative. The Japanese 10-year government bond yields an exciting negative 0.07%, while the German 10-year yields a very enticing negative 0.44% for those looking to guarantee a loss for 10 years. Any takers? These are interesting times to say the least. High quality European corporate bonds are being issued at negative yields for shorter-dated bonds, while longer-dated bonds yield less than 0.5%. I know if I ran a European company, I would be trying to borrow a substantial amount of money for as long as I could.
Why are interest rates so low? Three significant reasons are relatively low inflation, global central bank monetary policy, and the naturally cautious nature of bond investors. While unemployment remains extremely low at 3.6%, wage growth at 2.9%-3.1% seems under control, and inflation has remained moderate at 1.6%-1.8% for the last 12 months. Additionally, most developed markets’ central banks are focused on maintaining an extremely accommodative monetary policy in the near-term, which has kept global interest rates low. More importantly, because U.S. Treasury bonds yield significantly more than foreign sovereign debt, foreign demand for our bonds remains strong. Third, the naturally cautious bond investor remains concerned with global growth, especially with the coronavirus remaining front and center. The full extent of the human and financial impact and the duration of this event remain unknown. Based on the Center for Systems Science and Engineering (CSSE) at Johns Hopkins University, however, the number of people recovering from coronavirus has been exceeding the number of newly confirmed cases in the past few days. Bond investors are currently confident that the Fed, other central banks, and the Chinese government will adjust policies as appropriate to try to ensure the coronavirus does not derail the long-term global expansion the world has enjoyed since the great financial crisis.
So enough already. What does this all mean for my portfolio? Well, these lower interest rates have driven up bond prices. Bond prices are also benefitting from tightening credit spreads, further pushing down yields and hence driving strong fixed income returns in 2019 and so far in 2020. The stock market has benefitted enormously not only from easy monetary policy, which has propelled continued global growth, but also from lower discount rates. For illustrative purposes, the value of $1 of earnings annually in perpetuity discounted at 6% rather than 7% is 16.7% more valuable. Hence lower interest rates drive stock valuations; so if some of the interest rate declines are expected to remain for the foreseeable future, stock valuations will naturally benefit. Regarding corporate behavior, cheaper debt lowers interest payments and either allows companies to produce higher earnings, all else unchanged, or perhaps to increase leverage. Increased leverage can be used to fund positive-return capex projects, share buybacks, or acquisitions. Most acquisitions financed with 3-4% debt will be highly accretive to earnings. Finally, ignoring the magnitude of government debt, government deficits can potentially be less concerning to politicians when interest rates are so low. (To be clear, this is just math and has nothing to do with any political view.) The truth is low interest rates affect more than just your fixed income securities, so it is worth your time to occasionally pay attention to interest rates.
While fixed income yields are currently low on average, you should remember that a carefully constructed portfolio of 25-35 securities is very different than owning the entire fixed income market. ACM fixed portfolios are also extremely different than a typical pool of bonds or preferreds, which likely consists of many very similar securities. We have the flexibility to buy short or long-dated securities, investment grade or high yield, and bonds or preferreds. Even better, we are unconstrained by arbitrary style or maturity buckets so can choose to mix in all of the above as we deem appropriate. We are the farthest thing from a one-size-fits-all fixed income portfolio. So while yields will fluctuate, we remain focused on constructing attractive fixed portfolios that preserve and grow your capital over time.