Duration Bites

For a long time now (admittedly somewhat early) I have been warning of the dangers inherent in the long durations on bonds at the low yields of 2016-17.  In previous cycles, when yields were higher, the duration of the 30-year Treasury bond was typically around 15 years.  For most of last year, it was almost 22 years.  The same was true for long AAA municipals.

Since Jan. 1, the risks associated with those long durations have become only too apparent.  In January, total returns were -2.4% and -3.7% on the 10- and 30-year Treasuries and -1.6% on the longest munis.  Returns have been even uglier the first two days of February.  In the corporate high yield market, where interest income is greater and durations are shorter, returns have been positive.

Once again, a flattening yield curve and low yields overseas did not “protect” the long maturities.  The 2-30-year Treasury spread narrowed 5 basis points in January, but that was not sufficient to prevent painfully negative returns from the long maturities.  Yields in foreign markets rose in step with U.S. yields.  The yield on the 10-year German bund is up 30 basis points this year.  Those have been the patterns during every market selloff since the lows in yields in 2016.

This 2018 selloff has brought yields into much better alignment with market fundamentals.  Those fundamentals start with a strong economy.  The ISM and employment reports for January were reminders that the cyclical expansion has become quite robust.  The FOMC all but promised more rate increases this year and the Treasury projected a pace of debt issuance twice that of last year.  This, at a time when the Fed’s balance sheet reductions are at a $20 billion monthly pace and scheduled to increase each quarter.

I thought that the yield on the 10-year Treasury would be around 3 1/4% by year-end.  With a fed funds rate around 2 1/4% by December, the 2-year yield would probably be around 3% and, even with more curve flattening, the 10- and 30-year yields would probably be around 3 1/4% and 3 1/2%.  That, in my view, is still a reasonable outlook.

It is an outlook that implies more negative returns over the next 11 months on Treasuries and AAA munis maturing in 10 years and longer.  The outlook is somewhat  better for A/BBB munis and much better for investment grade and high yield corporates.  Corporate spreads are not generous, but still acceptable for a period of good economic growth.

Forecasting is always dangerous, but forecasting with a straight edge is especially foolhardy.  It was a mistake to assume that yields would stay at 2017 levels indefinitely, and it is probably just as wrong to assume they will keep rising indefinitely.  This correction might not be over, but it has created much better values in the intermediate segments of the bond markets.  It is probably still too early to start buying the longer maturities.

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