Longer-dated Treasuries have proven something of a wasteland for investors, but now there are some signs of improvement. The 10-year part of the yield curve “is a reasonable place to look,” says Kelsey Berro, a portfolio manager at JP Morgan Asset Management, although it depends “on your ability to withstand volatility and your time horizon.” .
The iShares 7-10 Year Treasury BondIEF, an exchange-traded fund, has an annual return of minus 11.4%, including interest payments, although it has outperformed recently, returning around 4% over the past three months. .
The drop in fixed income indices was exceptional in 2022, with a drop in the Global Aggregate index some 4 times higher than those generally registered in the last two decades. The inflationary shock and the reformulation of central bank policies have been very abrupt. We cannot ignore that the persistence of inflation and the initial economic resistance lead to a new appreciation, but in the last few months the yields of the 10-year Treasury bonds have been totally decoupled from the implied maximum of the Fed funds.
The US 10-year Treasury yield has been volatile, hitting its 52-week high of 4.23% on October 24 before falling sharply to around 3.4% in early December. It then reversed course again and rose to around 3.9% at the end of December, only to drop to around 3.6%. It must be remembered that bond prices and yields move in opposite directions depending on the relationship between coupon and price.
Duration is the sensitivity of a bond to changes in interest rates. Assuming longer duration may mean having additional, longer-term bonds in a portfolio. Those holdings are typically more sensitive to changes in interest rates than short-term bonds.
That has been a big problem for the last year. In its effort to rein in inflation, the Fed’s Federal Open Market Committee raised short-term rates seven times last year, most recently to a target range of 4.25% to 4.5%. That put pressure on bond prices. Berro points to the “growing evidence that both inflation and growth are reversing, and this should translate into a weaker labor market over time.”
From their point of view, you can expect to see another rate hike or two, which provides more visibility. “We feel more comfortable increasing portfolio interest rate sensitivity as we get closer to the end of the cycle of these rate increases,” argues JP Morgan.
Berro believes there are opportunities in high-quality assets at the 10-year part of the curve, including government debt, corporate loans and municipalities. However, the 10-year bond also presents risks, including volatility.
If the Fed ends up pushing interest rates higher and for longer than markets expect, it could put pressure on 10-year Treasury prices, lifting yields. “I don’t think it’s worth taking the risk that’s built right now in those [bonos] longer duration,” says Yung-Yu Ma, chief investment strategist at BMO Wealth Management.
Ma anticipates a softer economic landing “where growth slows but we don’t go into recession.” As a result, it prefers the shorter end of the yield curve, including the one-year US Treasury, which yields about 4.75%, more than a percentage point above the 10-year note. “It’s worth the extra yield boost, rather than stick with something longer,” Ma says, noting that he sees fed funds hit a rate that ends at 5%.
Ma views the 10-year Treasury note as “very expensive protection at this point,” adding that “you’re giving up some yield and you’re taking some risk that yields [a 10 años] actually go higher.”
Even if the Federal Reserve keeps interest rates higher for longer, there is at least one silver lining to 10-year Treasuries. The yield is currently around 3.6%, compared to 1.6% 12 months ago, before the Fed started raising rates. “That difference also provides an additional cushion if returns increase or remain stable,” says Berro.
The 10-year leg of the yield curve still carries plenty of risks, especially if inflation stays high for longer, but it’s definitely worth considering carefully, even as a small drawdown, experts say.