Not All Yields Are at Record Lows; Here's Where to Look for Opportunities
The flight to the U.S. markets since the British Brexit vote has sent many, but not all, yields to record lows. Virtually every market in which foreign investors participate has rallied strongly in recent weeks and has shown big yield declines thus far in 2016. The exception is the better-quality segments of the junk bond market, perhaps because foreign investors are not very active there.
BofA Merrill Lynch High Yield Master Index definition
In the Treasury markets, yields on maturities of five years and longer are down 85 to 90 basis points (bps; 100 bps equals 1.00%) this year and are at the lowest level on record. In the municipal market, 10- and 30-year yields are down 70 to 80 bps but are not at record lows. Back in 1950–1951, yields on 10-year AAA munis were slightly lower than the 1.30% reached last week. Yields on 10-year single-A munis were as low as 1.5% back then versus around 2.0% now. Since the financial crisis of 2008–2009, quality spreads in the muni market have stayed unusually wide—more than double what they typically were precrisis. As a result, the A and BBB muni yields are still well above all-time lows. The Bond Buyer 20-Bond Yield Index, which measures yields on long-maturity bonds with an average rating of AA/A , is now at 3.15%, the lowest since 1965 but far above the record low of 1.60% in 1951.
Yields on 10-year investment-grade industrials are down 100 to 110 bps this year, according to Bloomberg. Spreads to Treasuries have narrowed by approximately 25 bps since January 1. At around 2.50%, the 10-year A-rated industrial yield is very likely a record low. Even bank yields have declined almost 100 bps this year.
The high-yield corporate market has also rallied but, as the chart shows, not to record-low yields. Those yields increased sharply in 2015 as energy companies began to default, and most have not declined as sharply this year as in other markets. The 10-year BB and B yields are down only 40 and 60 bps, respectively, this year and are well above record lows. For example, the yield on the BofA Merrill Lynch BB market index fell below 4% in 2013 but is at 5.10% now. Yields in the CCC segment have declined by 200 to 300 bps this year—but from exceptionally high levels. As a result, the yield on the BofA Merrill Lynch CCC market index is still more than 700 bps above the modern-day low reached in 2014.
Investment implications
At these record-low yields, Treasuries and munis maturing beyond five years offer too little interest income to offset even small declines in principal values. For example, 30-year Treasuries or munis purchased today would likely suffer negative returns over a 12-month holding period if market yields in those sectors were only 15 bps higher a year from now. Because we expect the U.S. economy to continue to grow at a moderate 2.0% to 2.5% pace, we believe that those yields will rise more than 15 bps over the next 12 months. Conservative, short-duration strategies are preferable in these markets.
The outlook is much better in the high-yield corporate market, where sufficient interest income may offset modest declines in principal values. For example, at yields around 6%, the 10-year BB credits (the highest junk bond credit rating) would be expected to produce positive total returns, even if yields in this segment were to rise 75 bps over the next 12 months. And, because spreads to Treasuries are still 100 to 150 bps wider than the averages for a nonrecession period, an increase in yields of that magnitude is, in our opinion, unlikely over the next 12 months.
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The views expressed are as of 7-11-16 and are those of James Kochan, and Wells Fargo Funds Management, LLC. The information and statistics in this report have been obtained from sources we believe to be reliable but are not guaranteed by us to be accurate or complete. Any and all earnings, projections, and estimates assume certain conditions and industry developments, which are subject to change. The opinions stated are those of the authors and are not intended to be used as investment advice. The views and any forward-looking statements are subject to change at any time in response to changing circumstances in the market and are not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally, or any mutual fund. Wells Fargo Funds Management, LLC, disclaims any obligation to publicly update or revise any views expressed or forward-looking statements.
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