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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.

Kevin R. Caron, CFA
Senior Portfolio Manager
973-549-4051

Chad Morganlander
Senior Portfolio Manager
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Matthew Battipaglia
Portfolio Manager
973-549-4047

Steve Lerit, CFA
Client Portfolio Manager
973-549-4028

Paul Clark, CFA
Senior Portfolio Manager
Municipal Fixed Income
415-364-2635

Rick Marrone
Senior Portfolio Manager
Municipal Fixed Income
415-364-2917

Daniel Urbanowicz
Senior Portfolio Manager
Municipal Fixed Income
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Suzanne Ashley
Internal Relationship Manager
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Eric Needham
External Sales and Marketing
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