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26 November 2018
By Laura Frost
The market for 30-year US government debt has often been described as a “giant anaconda”: It draws little attention as it sleeps most of the time, but when it wakes up, everybody around it shakes in fear.
This is because the investment returns available on long-term bonds issued by the government of the world’s largest economy are a pivotal reference point for both borrowers and investors. US government bonds, also known as Treasuries, are loans extended by investors to the government in exchange for regular interest payments.
Like those of the giant anaconda snake, the moves in 30-year US Treasuries can be painful. Yields on Treasuries – essentially, interest payments as a percentage of the bond’s price – play a major role in determining US mortgage rates, as well as the price that governments and companies around the world pay to borrow money.
The yields on 30-year US Treasuries have been on a downward trend since the late 1980s. When yields go down, the prices of bonds go up, so bond prices have rallied over the same period, reflecting growing demand from investors.
The fundamental attraction comes in the prospect of regular income payments for three decades from the US government, which is widely seen as unlikely to default on its debts.
But yields are not only a function of demand, they also depend on supply. The more debt that has been issued, the less of a scarcity premium it can command – unless, of course, there are more willing buyers.
Since the financial crisis of 2008, the US government has issued considerable amounts of debt, but strong demand has been sustained by the combination of investor demand for “safer” assets (like US Treasuries) and loose monetary policy known as quantitative easing (QE). Under QE, central banks have been buying up assets, mostly government bonds, to encourage investment elsewhere in the economy and thereby support economic growth.
For the first time in four years, yields on 30-year US Treasuries breached the symbolic 3.25% mark in October 2018. They have since risen further. In early November, the US Treasury sold 30-year bonds at a yield of 3.42%, the highest at auction since August 2011.
The forces that put downward pressure on yields have now reversed. The Federal Reserve, the US central bank, stopped QE in 2017, and asset purchases are now being wound down in Europe.
As demand has declined, supply has grown as more bonds have been issued to cover higher US government borrowing. Tax cuts and higher spending have pushed the US budget deficit to 3.9% of economic output – the largest it’s been since 2012.
This fiscal stimulus, together with robust economic growth, has raised expectations for US inflation. The rate of inflation is a key determinant of bond yields, since investors will demand higher returns when prices are rising more quickly, to preserve the real value of their returns.
Expectations of higher inflation in the US over the medium- to long-term would likely push up the yields on long-dated US Treasuries. These factors combined point towards a continued rise in 30-year US bond yields, in my view.
The implications of rising yields for investors who own these 30-year US Treasuries are obvious. Because prices fall when yields rise, the value of these assets would be expected to fall, leading to capital losses.
When yields on long-dated bonds are so low, their value is highly sensitive to changes in interest rates. For instance, when the yields on 30-year US Treasuries are 3.36% - as they were on 16 November 2018 – a one percentage point increase, to 4.36%, would push the value of the bonds down by almost one-fifth. For holders of these bonds, this is the squeeze of the anaconda.
But the impact is much wider, since the investment returns available from long-term lending to the US government are a benchmark for other global assets.
As lending to most other companies and governments is generally seen to carry greater risk, yields on their bonds would be expected to rise in line with that of US Treasuries’. Higher rates of interest push up the cost of borrowing everywhere.
Crucially, as 30-year Treasury yields rise so will US mortgage rates, which are commonly of a similar length. Fixed interest rates on 30-year mortgages in the US have historically run at between 1% and 2% above the yield on 30-year US Treasuries.
Higher costs of borrowing for companies and households would undoubtedly have an impact, denting investment and consumption, especially when debt levels are at historically high levels.
However, the US economy is in robust health. So long as the economy continues to grow, we should expect few companies to default on their debt repayments – good news for bondholders. We should remember, too, that while rising yields might lead to some capital loss, bond investors stand to receive higher income returns relative to their investment.
Bond yields cannot continue to fall forever. The turning of the ‘anaconda’ might bring discomfort, but could herald a return to more “normal” investment return for global bond investors.
Please remember that past performance is not a guide to future performance. The value of investments goes up and down and will fluctuate over time, and you may not get back the original amount you invested. The views expressed in this document should not be taken as a recommendation, advice or forecast. We are not able to give any financial advice. If you’re at all unsure about the suitability of your investment, please speak to a financial adviser.