The latest U.S. import? Lower interest rates

As published in the Minneapolis Star Tribune 7/20/19.

Of all the ways to make a bet, why wager on a bet that is guaranteed to produce a loss? That’s the question we asked ourselves when reviewing the state of a global marketplace that includes roughly $13 trillion worth of bonds paying a negative yield.

$13 trillion of investment-grade corporate and government debt are owned by investors who stand to lose money simply by holding their bonds to maturity. Data from the Bank of International Settlements estimated the total market value of all outstanding bonds worldwide to be $100 trillion, as of Dec. 31, 2017.

Even if we account for the growth in new issuance since then, more than 10% of all bonds globally carry negative yields. Half of all European government bonds have negative yields. And 20% of corporate bonds in Europe can make that claim.

U.S. investors are now feeling the effects. The 10-year US Treasury, a generally accepted proxy for the U.S. bond market, saw its yield decline from 3.25% last October to 1.94% in early July. Some of the drop can be attributed to a change in policy from the Federal Reserve.

After increasing its benchmark Fed Funds rate four times in 2018, Chairman Jerome Powell and the Fed hit the brakes in January. There have been no Fed hikes in 2019 and consensus expectations show a near 100% probability the Fed will cut rates lower in late July.

You could be exposed

Part of the fall in U.S. bond yields, however, is due to an inevitable “closing of the gap” between U.S. interest rates and those in the rest of the world. We have in essence imported lower interest rates from abroad.

Unprecedented amounts of stimulus from the world’s central banks undoubtedly played the lead role in how bond yields could be pressured so low. Stagnant growth since the Great Recession in much of the global economy (outside the U.S.) has also increased demand for conservative assets. If the European Central Bank (and others) helped pressure yields into the red, who is still buying these bonds despite expecting to lose money? It might be you.

The rise in popularity of passive investing means more people are investing in an index without ever looking under the hood.

If investors who own bond funds take a look at the ingredients, there’s a good chance they won’t like what they see.

With a market capitalization of more than $50 trillion, the Bloomberg Barclays Global Aggregate Bond Index is one of the largest fixed income benchmarks in the world. It has more than 23,000 individual issues (bonds). When weighted by market-cap, a full 20% of the index has a negative yield-to-maturity.

If you have fixed-income exposure in your company 401(k) or 403(b) plan, some of the money you consider most safe may pay less than zero. Most employer-sponsored plans like 401(k)s have a limited menu of investment choices and nearly all of them include index funds. The “fixed income” funds are typically even more limited and the default choices often steer participants toward passive options.

Own any “Target Date” or “Lifecycle” funds? Such options include fixed income exposure, often via passive global indexes.

Interest rate outlook

It’s important to point out that recent performance of bonds and bond funds are a poor indication of the yields they might offer.

Most bond investors have been smiling at their year-to-date performance since falling interest rates have boosted total returns. Don’t let recent gains prevent you from learning more about your fixed income investments.

Where might interest rates go from here? At least two future Fed cuts are already priced-in, so bond yields won’t necessarily sink lower even if Powell & Co. meet expectations.

On the other hand, the global recession watch has begun. Inflation has been stubbornly slow to accelerate. And the Fed has shown a willingness to cut rates even with U.S. stocks near all-time highs. All suggest rates will likely remain lower for longer.

Low interest rates, it seems, are here to stay. Invest accordingly.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.

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