2 Views: Are Negative US Rates Coming?

August 14, 2019

ETF.com: Where do you see the 10-year Treasury going in the short term and long term?

Hill: In the short term, we expect the market to stabilize in this new range, i.e., in the mid 1%’s. This will persist until there’s guidance as to whether the attempted midcycle cuts avert a recession. If so, look for 10s [10-year Treasury] to push back toward the 2-2.5% range. If not, and the economic backdrop continues to deteriorate amid the trade war, we’d expect another leg lower from here and possibly setting new all-time low yields.

Arone: In the short term, 10-year Treasury yields have fallen too far and too fast. I expect that as market volatility wanes, trade tensions cool and global central banks ease, 10-year Treasury yields will rise closer to the 2% threshold versus falling precipitously. Prospects for economic growth and inflation are not nearly as dire as what’s currently reflected in 10-year Treasury yields.

That said, it’s hard to make the case for higher long-term rates. Both cyclical and structural forces are combining to keep a lid on the long-term outlook for 10-year Treasury yields. Below-trend economic growth rates, benign inflation and negative term premium from wildly aggressive monetary policies will continue to dampen yields.

ETF.com: In this environment of plunging Treasury yields and uncertainty about the global economy, how do corporate bonds fare?

Arone: Despite recent market turmoil, credit spreads have behaved reasonably, widening only modestly. The economy is still expanding, albeit at a slower rate versus last year, and corporate profits are still growing incrementally. As a result, default rates for corporate bonds should remain low.

However, the compensation that investors are receiving for taking on interest rate risk (duration) and/or credit risk is quite low compared to historical levels, especially this late in the credit cycle. Maintaining existing allocations to corporate bonds make sense, but investors should look for opportunities to upgrade credit quality and shorten duration.

Hill: The negative growth shock out of the trade war should, at face value, be credit negative and push spreads wider. We would also expect widespread outflows as investors de-risk. We’re also attentive to the huge amount of BBB-rated credit that could be at risk of falling out of an investment-grade classification.

ETF.com: How should investors position their fixed income portfolios? What types of segments should they overweight/underweight, and what types of ETFs should they buy?

Hill: Treasuries continue to act as a natural hedge against macroeconomic risk. With expectations of additional Fed cuts looking to try to boost forward inflation expectations, TIPS look attractive despite very low (but still positive for now) real yields. As for other determinations, it would depend on the investors’ risk tolerance and investment horizon.

Arone: Investors should recognize that the risk/return dynamics for fixed income investments are skewed to the downside. The compensation that investors are receiving for interest rate risk (duration) and credit risk are 30-50% below long-term historical averages. Investors aren’t being rewarded for duration or credit risk right now.

However, the U.S. economy isn’t likely to enter recession anytime soon, and corporate profitability is still healthy. So, maintaining existing positions in corporate bonds and below-investment-grade investments may be prudent.

Yet when adding capital to fixed income allocations, I suggest a barbell approach; for example, adding to long-term and intermediate Treasuries with the SPDR Portfolio Long Term Treasury ETF (SPTL) and the SPDR Bloomberg Barclays Intermediate Term Treasury ETF (ITE) as a hedge against equity risk and microbursts of volatility, especially this late in the credit cycle.

Balance those allocations with investments—such as the SPDR Portfolio Short Term Corporate Bond ETF (SPSB), the SPDR Portfolio Intermediate Term Corporate Bond ETF (SPIB) and the SPDR DoubleLine Short Duration Total Return Tactical ETF (STOT)—that enable the investor to move up in credit quality and shorten duration while still maintaining a competitive yield. This compensation more appropriately balances the risk/reward trade-off for fixed income investments.

​Email Sumit Roy at [email protected] or follow him on Twitter @sumitroy2

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