Interest rates on bonds are at very low levels. The decline in the United States rates follows those of other sovereigns like Germany, the United Kingdom, and Japan (Chart A, below). In turn, global rates are following a long-established, declining secular trend. That trend leads to “negative” rates with more than $17 trillion in such debt circulating globally (Chart B, below). The defeating of inflation and worries of deflation may be behind this trend. Still, other factors may also be at work.

Chart A

U.S. Long-Term Treasury Yields vs. Average Foreign Yield (Germany, United Kingdom, Japan)

Chart B

Aggregate Global Negative Yielding Debt
($ Market Value)

Whatever the reason, the decline in U.S. Treasury rates means bond portfolio values are flush, but lower potential returns may lie ahead. Consider that today’s thirty-year, zero-coupon U.S. Treasury bond is now priced to return just 1.6% annually (Chart C, below). Not only is this below the 1.7% inflation forecast priced into the Treasury Inflation-Protected Securities (TIPS) market, but near past historic lows too.

Could the latest slide in rates be explained by COVID-19 and a temporary falloff in growth? Of course. So it is reasonable to imagine that a return to faster growth after COVID-19 might also lead to higher yields on Treasury bonds. An immediate rise to 3%, for example, would roughly translate into 30% decline for the 30-year zero-coupon Treasury. Such a decline would take back much of the run-up in the bond’s price associated with 2020’s pandemic and slowdown.

Chart C

U.S. 30-Year, Zero-Coupon Treasury Yield

Japan

While “normalization” to higher levels is still our long-run forecast (see Viewpoint 2020), it is plausible that we follow Japan’s lead. In this scenario, global growth slows to a crawl, deflation remains a persistent threat, and rates remain stuck well below historical levels. Today, for example, a 30-year Japanese Government Bond yields a mere 0.6%, a full 1.0% below that of a similar U.S. bond. If we repriced the 30-year Treasury bond using Japanese rates, the U.S. bond would rise in price by roughly 30%.

We are not forecasting the “Japan” scenario as the most likely one. Instead, we expect rates to move higher as global growth picks up in 2021-2022. Still, it is worth considering what an alternative scenario might look like if we are wrong.

1902

To find a similar situation, we need to go all the way back to 1902. According to The Financial Review (February 1903), a 2% coupon U.S. Treasury due in 1930 traded at $109.625 in March 1902 to yield 1.6%. While that rate marked the low-water mark for Treasuries, that environment of low rates remained for several years. In 1906, for example, buyers were still anxious to buy Panama Canal 2% bonds at $104 to yield 1.6%. But by 1920, long-term Treasury rates had risen back to 4-5.5%. Still, prosperity in America advanced rapidly over the 1902-1920 period without a major setback despite higher interest rates.

Roman ZIRP

It is hard to find other examples of rates lower than today — for this one we dig into antiquity. A scan of Sidney Homer and Richard Silla’s A History of Interest Rates reveals one short period in Roman history. Following the Gallic invasion of 387 B.C., Rome was beset with distress, destruction, and debt. A series of government actions were taken to ease the debt burden. Around 342 B.C., interest was banned altogether. Still, the Roman’s “zero interest rate policy” (ZIRP) only held for a short time, and the legal rate returned to 8.3%. So much for Rome’s early experiment with Zero Interest Rate Policies!

Final Thoughts

COVID-19 exposed weaknesses in the global economy in 2020, stripping to the bone returns to be expected from bonds. U.S. interest rates remain above levels available in other parts of the world but near historic lows. While our forecast called for a process of rate normalization this year, COVID-19 pushes that process off to the future. For now, low interest rates are leaving investors with lower expected returns than before. In this low-yield environment, managing credit quality and duration becomes more critical. Tactical asset allocation choices also become more of a focus for investors looking to potentially outperform a passive bond benchmark.

Disclosures:

WCA Barometer – We regularly assess changes in fundamental conditions to help guide near-term asset allocation decisions. Analysis incorporates approximately 30 forward-looking indicators in categories ranging from Credit and Capital Markets to U.S. Economic Conditions and Foreign Conditions. From each category of data, we create three diffusion-style sub-indices that measure the trends in the underlying data. Sustained improvement that is spread across a wide variety of observations will produce index readings above 50 (potentially favoring stocks), while readings below 50 would indicate potential deterioration (potentially favoring bonds). The WCA Fundamental Conditions Index combines the three underlying categories into a single summary measure. This measure can be thought of as a “barometer” for changes in fundamental conditions.

Standard & Poor’s 500 Index (S&P 500) is a capitalization-weighted index that is generally considered representative of the U.S. large capitalization market.

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The Washington Crossing Advisors’ High Quality Index and Low Quality Index are objective, quantitative measures designed to identify quality in the top 1,000 U.S. companies. Ranked by fundamental factors, WCA grades companies from “A” (top quintile) to “F” (bottom quintile). Factors include debt relative to equity, asset profitability, and consistency in performance. Companies with lower debt, higher profitability, and greater consistency earn higher grades. These indices are reconstituted annually and rebalanced daily. For informational purposes only, and WCA Quality Grade indices do not reflect the performance of any WCA investment strategy.

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