Bond Bulls Charge Ahead, Challenging Consensus on Rising Yields
Contrarians see buying opportunity as investors drive yields higher on bets for rebounding growth and rising inflation
Robert Tipp doesn’t buy the popular Wall Street view that U.S. government bond yields are bound to keep rising this year, though he allows that they could before likely falling later.
The chief investment strategist at PGIM Fixed Income, Mr. Tipp is among a relatively small group of contrarians who have bet for months that the forces lifting bond yields—expectations for a post pandemic surge in growth and inflation, increased government borrowing—are no match for the structural factors that have suppressed them for decades.
Mr. Tipp’s position is notable because he and other so-called bond bulls have generally been right about the direction of Treasury yields over the past 30 years. That gives their perspective some added ballast as investors confront a set of highly unusual circumstances, including the possible end of a pandemic and an unprecedented surge in peacetime government spending and tax cuts.
The yield on the benchmark 10-year U.S. Treasury note, a key driver of interest rates across the economy, topped 1.7% earlier this month for the first time since the start of the coronavirus pandemic, settling Friday at 1.658%. That was up from 0.913% at the end of last year but down from around 5% 15 years ago and 8% 30 years ago.
Yields, which move in the opposite direction of bond prices, tend to rise when investors expect faster growth and inflation—which can lead to higher short-term interest rates set by the Federal Reserve—and fall when they anticipate a weaker economy.
Investors will get a fresh look at the strength of the pandemic recovery this coming week with the release of the monthly jobs report for March, as well as new data on manufacturing and construction activity.
Most investors believe that long-term factors, such as aging populations and lackluster productivity growth, have dragged on yields in recent decades. Even so, they are betting that inflation and rates are still poised to rise due to massive fiscal and monetary stimulus and the broadening distribution of coronavirus vaccines.
For longtime bond bulls, however, the last three months have been a buying opportunity, the latest of a string of episodes over the years when investors have too easily dismissed long-run trends amid a burst of economic optimism.
“When the economy recovers strongly like it is right now, investors push up yields, but a lot of times, actually most of the time, they tend to pass through fair value and keep going,” Mr. Tipp said.
Betting on Treasurys now isn’t without risks. Fixed-income investors wager on the direction of Treasury yields by adjusting a measure known as duration in their portfolios. Roughly corresponding to the time it will take investors to earn back the price they have paid for bonds, duration also indicates how sensitive bonds are to changes in interest rates.
As a rule of thumb, for every percentage point that a bond yield goes up or down, its price moves in the opposite direction by a percentage equal to its duration. Managers of fixed-income mutual funds generally don’t diverge too much from the average duration of a benchmark index. But they do try to outperform their benchmark in part by setting the duration of their portfolio a little above or below that of the index—with a longer duration often amounting to a bet that yields will fall and a shorter duration that they’ll rise.
In recent years, PGIM Fixed Income’s flagship Total Return Bond Fund has typically run a duration at or above its benchmark. That’s just a small part of its overall strategy but one consistent with Mr. Tipp’s view that factors like demographics and mounting private-sector debt would eventually pull yields lower, regardless of short-term fluctuations.
For the most part, the bet has paid off. Through March 24, the fund was in the top 24% of its Morningstar peer group, based on annualized 10-year total returns and only including the oldest share classes of each fund with a track record that long. This year, though, it is second-to-last out of 156 funds, losing 4.1%, according to Morningstar data, or about 3 percentage points worse than the average.
Another fund with a longer-than-average duration, Western Asset’s Core Plus Bond Fund, has had similar results. Its returns have exceeded its benchmark since Sept. 30 and put it in the top 8% of the same Morningstar group over the past 10 years but are last in the group this year at negative 4.3%.
John Bellows, one of the fund’s portfolio managers, said duration positioning is part of the fund’s diversification strategy, which includes relatively heavy investments in riskier types of debt like lower-rated corporate bonds. A longer duration offers some protection from economic slowdowns when riskier debt is at its most vulnerable but Treasury yields tend to fall.
The fund’s current position, however, also reflects his view that the “Treasury market is very optimistically priced at the moment.”
Specifically, he said, yields reflect expectations that the Fed’s benchmark federal-funds rate will remain near zero this year but start climbing at the end of 2022, then remain at 2.5% for about five years without causing inflation to fall below its 2% target. All of that, he said, seems ambitious considering inflation struggled to reach the Fed’s target for years before the pandemic.
For their part, Fed officials have pledged to be unusually patient about raising rates in the coming years. They have said that they want to see actual evidence that inflation can be sustained at their target rather than moving ahead of time, as they have in past economic expansions.
In their most recent projection, in mid-March, 11 out of 18 officials indicated that they thought rates would remain near zero through 2023.
Their median forecast showed annual inflation accelerating to 2.4% in the fourth quarter of this year and remaining at or slightly above 2% for the next two years. But Fed Chairman Jerome Powell has played down inflation risks, telling lawmakers recently that the effect on inflation from government spending will likely “be neither particularly large nor persistent.”
On Friday, the Commerce Department reported that one of the Fed’s preferred inflation gauges, the core personal-consumption expenditures price index, had climbed 1.4% in February from a year earlier. That was an unexpected drop from 1.5% the previous month.