Since it became inverted in June of last year, much ink has been spilled and comments devoted to the predictive powers of the US Treasury curve.
The textbooks tell us that, under normal circumstances, a bond market’s maturity curve slopes upwards from left to right. This makes sense. All things being equal, investors should, for a number of reasons, demand a higher return for committing their capital over a longer time scale.
And for the majority of time, that has indeed been so: in the case of the US Treasury market, for example, since 1st June 1979 (the furthest back we can find data) to the time of writing, the yield on the 10-year benchmark issue has exceeded that of the two-year on 10,005 of 11,843 trading days, or 84.5% of the time*. (Source: https://fred.stlouisfed.org/series/DGS10)
Last week’s third quarter GDP print may, as one of the research services to which we subscribe described, have been “stunningly strong”, but if the bond market is to be believed, all is not well. Guided by history, conventional wisdom suggests that a market in which the yields on bonds with long-dated maturities trade below that of shorter-dated issues implies that tough economic times are ahead and is seen as a reliable indicator of a forthcoming recession.
How reliable? Well, each of the 10 recessions experienced by the US economy during the last 70 years has been preceded by an inversion in the Treasury curve. In fact, EVERY US recession on record has been foreshadowed by a downward sloping yield curve. It is also the case, however, that not every curve inversion has been followed by a recession – according to market historians, during the post-WW2 era there has been one instance of a “false signal”, in the mid-1960s.
Reliable then, but not foolproof.
Currently, in spite of this indicator’s hit rate and the immutable maxim within our industry that “this time is different” are the most dangerous words in investing, opinion among forecasters is divided pretty evenly over whether the US is headed for a recession. Given the unprecedented nature and sequence of events over the past three years – among others: a pandemic, a war, massive fiscal largesse – this is perhaps unsurprising. As our CIO Kevin Boscher reminds us, one can put forward a cogent argument for either eventuality, based on the evidence presently available.
Given this lack of visibility and the resulting level of uncertainty among even the sharpest minds, it is important, in our view, to avoid aligning investment portfolios with one specific outcome.
For the fixed income portion of our models, this is manifested in a number of ways. Within the core credit component, exposure to investment grade and high yield debt, which perform best in favourable economic environment, is largely confined to shorter-dated bonds. In that way, in addition to their low sensitivity to interest rate movements, any widening in yield spreads resulting from investors’ concerns over a deterioration in corporate conditions is mitigated by a pull to par as they approach maturity.
In what could be described as a “barbell” approach, those “low impact” allocations are complemented by exposure to strategies that, through long-dated government bond holdings, are positioned to benefit from the interest rate cuts that can be expected in the event of a deeper economic downturn and, in specific circumstances, a worsening credit backdrop. Other specialised holdings, which include insurance-linked bonds, asset-backed securities and infrastructure debt, provide further layers of diversification.
Thanks to the compelling combination of attractive income yield, capital upside and a positive asymmetrical return profile that comes with a meaningful degree of certainty provided by this blend of investments, we believe that the outlook for bond investors is as favourable as has existed for many years.