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The implications of negative real yields

| July 17, 2020

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.

The market currently expects investors in the safest forms of debt to lose money over the next decade. Not in nominal dollars, of course, but in real dollars. In other words, investors in Treasury debt will lose purchasing power. That poses a problem for portfolios such as endowments or others designed to cover a portion of operating expenses for the owners. Other than resigning themselves to falling short on expenses, investors either have to encourage their clients to cut expenses or take more risk. The market will likely see an aggressive grab for risk.

The Treasury market has now priced to a real yield of around -84 bp over the next 10 years (Exhibit 1). Investors in today’s 10-year Treasury at a 0.63% should expect to lose about 84 bp of purchasing power every year as inflation runs above the coupon on the debt. That seems entirely plausible with former Fed Chair Bernanke and Chair Yellen noting the possibility this week of yield curve caps. Fed Governor Lael Brainerd this week also suggested, after noting recent low inflation, that “refraining from liftoff until inflation reaches 2% could lead to some modest temporary overshooting, which would help offset the previous underperformance.”

Exhibit 1: Real yields have fallen toward their lowest level in 14 years

Source: Bloomberg, Amherst Pierpont Securities

For many portfolios, taking enough risk to overcome steadily declining purchasing power may turn out harder than it seems. It is a truism that higher risk earns higher return. But it is only a truism in the long run. In the short run, higher risk can generate higher losses, making it that much more difficult for the portfolio to rebound. A portfolio that loses 5% only needs to gain 5.27% to get back to even. A portfolio that loses 10% needs 11.12% to recover. The bigger the loss, the bigger the gain the portfolio needs in the next period. The prospect of taking more risk and then falling further behind may freeze some portfolios in their current risk positions until accumulating expenses force the portfolio to adjust.

The best way to add risk is to diversify into exposures outside of the ones already in a portfolio. This gets beyond a common view of adding or subtracting risk as a limited exercise in asset allocation or in adjusting existing risks, such as duration. Adding a portfolio of diversifying risk should add return while limiting the kind of sizable drawdown that might come from adding duration alone, for instance, or increasing allocation to existing weaker credits.

The implications of current negative real rates and asset returns in recent months argue for going underweight Treasury debt and neutral agency MBS and adding risk in investment grade corporate and structured credit, particularly in new names or sectors. Yield premiums for owning less liquid assets should also compress into 2021 and help add return. Investors should explicitly include liquidity as a risk dimension. That opens up a wide range of investments from smaller sectors of corporate and structured credit—smaller issuers in the corporate world, less frequently issued types of assets in structured credit. It includes 144A debt and lending in the private debt markets. It includes forms of term repo, too.

A reasonable response to today’s market is to begin building new risk exposures. Each one on its own might take a portfolio beyond its traditional preferences. Together, they may add return and still keep the portfolio in bounds.

* * *

The view in rates

The Fed’s dots, fed funds futures and OIS all price a Fed on hold through 2022, with futures and OIS pricing a small chance of negative rates in 2021 and the Fed on hold at least into mid-2023. The current 0.63% rate on 10-year Treasury debt implies an average real rate of -84 bp and inflation of 147 bp. Real rates have generally continued to fall and implied inflation has continued to climb since mid-March. That should keep pressure on the yield curve to steepen from 2-year to 10-year and from 5-year to 30-year. After steepening since March, in recent weeks, the curve has flattened.

The view in spreads

The nominal spread of par 30-year MBS to the Treasury curve 5- and 10-year blend has dipped recently below 100 bp as investment grade corporate spreads continue to tighten. High yield spreads have tightened recently as well, despite elevated equity portfolio volatility. As spreads tighten in the highest quality assets, investors will have to move to the next tier of higher risk to get sufficient spread, but it is likely to happen. Spread compression across rating categories or credit quality is highly likely. There is fundamental risk in the most leveraged corporate balance sheets, and only there might spreads continue lagging the rest of the market.

The view in credit

The downside in leveraged credit outweighs the upside for now. Beyond the current uptick in Covid-19 in the US, the arrival of the school year in the next two months should create an important test of the ability to safely assemble people indoors. If that proves difficult, then potential productivity and growth should fall. Many investment grade companies have stockpiled enough cash to survive protracted slow growth, but highly leveraged companies and consumers are at risk. Prices on some sectors of leveraged loans, rating agency downgrades in leveraged loans and high yield and rising bank loan loss reserves signal a wave of distressed credit. Rising unemployment and delinquency rates in assets from MBS to auto loans show pressure on the consumer balance sheet. However, monetary and fiscal policies are both shoring up these fundamentals for now. The course of leveraged corporate and consumer credit also depends on renewal of CARES Act unemployment benefits and support for small businesses, along with moratoriums on eviction and foreclosure.

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