Double Trouble

Record low Treasury yields are rightly attracting lots of media and investor attention. Few have noted, however, that those low yields also imply record long durations. For example, the duration of the 30-year bond is now 23 years, not a great deal shorter than the duration of the 30-year STRIPS. In years past, the “rule of thumb” was that the duration of the bond was half the maturity or around 15 years. But that was when yields were in the 5-8% range, not 1-2%. A 23-year duration means that market yields need rise only 10 basis points over the next 12 months to produce a negative return on the 30-year bond for that holding period.

But, there is another, more ominous, potential problem for bonds–the flat yield curve. What will happen if or when the curve regains a positive slope? In past cycles, flat curves emerged after periods of Fed tightening that sent short-term rates sharply higher and bond yields somewhat higher. To 5-51/2% in 2006, for example. Those high rates and yields eventually led to recession, Fed easing, short-term rates falling more than bond yields and a steepening of the curve. Bond prices actually rose as the curve steepened.

That scenario is impossible today. If, in the months or years ahead, a positive slope emerges, it must involve a significant increase in bond yields and a significant decline in bond prices. And, with yields this low and durations this long, even a modest steepening would inflict big losses. An increase of only a percentage point in the long-bond YTM would push the price down by more than 20 points.

To be sure, with the focus now on the risk of a recession, curve steepening is not on investors’ radar. Nobody is talking about it. If, however, the economy avoids a recession and rebounds from a first-half slowdown, market participants will need to consider the risks presented by super-low yields and an untenable yield curve. We might even see the revival of a term we veteran bond people heard in the 1970s, i.e., bonds have become “certificates of confiscation”.

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