When investors are frustrated and confused about where the markets are heading, they do what comes naturally—they buy bonds.
Janet Yellen’s decision Thursday to keep short term interest rates at zero-- where it has stood since 2006--found traders reaching out for temporary relief in the form of investments that offered low risk, albeit small returns i.e. short-to-medium U.S. Treasuries and investment-grade corporate bonds.
Investors have been turning to bonds for months as global turmoil began and uncertainty about the Fed’s approach caused insecurity in U.S. markets. The slowdown in China may have started the ball rolling as well as the division amongst analysts as to the true strength of the U.S. economy. Bonds remain one of the few instruments left that offer liquidity and income in an economic state of restrained inflation, measured global growth and continued speculation on the Fed’s next tightening campaign.
Bonds remain one of the few instruments left that offer income and liquidity in an economy pressured by restrained inflation….
European Bonds
According to Rick Rieder, chief investment officer of global fixed income at BlackRock (BLK.N), the world's biggest asset manager with $4.7 trillion in assets under management, “even European bonds are worth a look.”
In fact, European Central Bank Executive Board member Benoit Coeure said Friday that the bank has flexibility to extend bond buying beyond September 2016 if called for. This statement caused a broad rally in free debt in Europe and provided an additional boost for Treasuries.
Lower bond yields in Europe make higher-yielding U.S. Treasury debt more attractive for buyers. The yield on the benchmark 10-year Treasury note was 2.155%, down from 2.215% Thursday. Yields work in the opposite direction of prices so that when bond yields fall, prices rise.
Many bond firms, anticipating (correctly) that the Fed would leave rates in tack, bought up U.S. Treasuries in various maturities to the tune of $1.1 billion in the week ending September 16th. Pimco Total Return Fund, one of the world's largest bond funds, posted gains of 0.26 for the week while Barclays' U.S. Aggregate bond index, the most widely followed U.S. bond market benchmark, ended the day up 0.49 percent on Thursday, its biggest one-day upsurge since the beginning of July.
Traders are predicting the yields on long-term Treasury bonds will continue to rise this year in line with an improving U.S. economy. In addition, buying long term bonds is a means of keeping inflation down as the value of long-term bonds is less influenced by the Fed's short-term interest rate policy and more affected by global growth and the inflation outlook. Inflation can be detrimental because it diminishes bonds' fixed return over time.
Inflation at 2 %
Meanwhile, inflation in the U.S. has remained around 2 percent, helped by the commodity market that has been steadily falling. China's sudden decision last month to weaken the Chinese yuan sent many emerging-market currencies crashing against the dollar and this helped to keep to inflation down while increasing the appeal of long-term Treasury bonds.
Analysts point to other reasons for holding on to existing bonds or purchasing new ones. The odds of a Fed hike in the near future are quickly fading and together with a further drop in oil prices, the Fed has little reason to do so.
Deflation, present in many countries and pending in many others including the eurozone, makes current Treasury note and bond yields attractive. Quantitative Ease, currently underway in Japan and soon to be followed in the eurozone, makes more money available to invest in U.S. Treasuries.
Another reason for buying bonds is that foreigners are also buying them. Of the $13 billion in sales of 30-year Treasuries in December, 50% were purchased out of the U.S.
Moreover, U.S. Banks must now comply with a new ruling requiring them to hold more liquid assets and 60% of these must be backed by the federal government.
Long Treasuries continue to be attractive to pension funds and life insurance companies that want their long-maturity liabilities to match similar duration assets. At the same time, baby boomers are aging and they favor Treasuries which reduce the riskiness of their portfolios despite their low yields.
Risks of Long Term Bonds
The drawbacks to holding long term bonds do exist, however. Should the Fed decide to keep interest rates lower for longer than expected, investors would worry that the Fed could not react to inflation concerns fast enough and this would push them to sell their long term bonds.
There is also concern that foreign central banks would sell off their long-term Treasury in order to fund waning economic growth in their countries. This is what occurred in July when China sold considerable long-term Treasury bonds before weakening the yuan in August. This resulted in bond yields holding their own during the market collapse.
As with most financial matters these days, there are no certainties and there will always be differences in the way investors interpret the same data and come up with varying conclusions. Now that the Fed has made its decision for the time being, economists are rearranging and reorganizing their forecasts but are basically laying low and encouraging investors to take it slow and cut down on the risk.