Treasuries have a new buyer in town, adding to its appeal as a liquid safe haven. The Fed has committed to expand its balance sheet to include greater purchases of Treasuries and bonds from corporate issuers in good standing. There is no expiry date for this policy initiative. The longer the current state of affairs continues, the more possible it becomes that negative yields in the US become a possibility in the future. We don’t find this to be a cataclysmic scenario for sovereign bond returns as pundits would have us believe.
Treasuries show the most stable and predictably lower variability of returns, which can benefit portfolios in times of distress and uncertainty.
Lower (negative) yields still mean higher bond prices
A possible consequence of monetary policy, unintended or otherwise, is pushing Treasury yields closer towards negative levels. Treasuries have until now remained among the ‘high yielding’ developed market issuers as the yields of other investment grade developed market sovereign bonds have dipped into negative territory.
Given the inverse relationship of price and yields, a continually falling yield that goes negative is the consequence of a continually rising price. Although the math of total returns for bonds can be complex, it is worth being mindful that the price component of the total return calculation continues to be additive to total returns (as long as bonds are not held to maturity). In the case of yields falling into negative territory, there will be corresponding capital gains from price appreciation.
Japanese government bond returns rose as yields turned negative
The yield on Japanese government bonds (JGB’s) became negative in 2016 (thus dipping below the zero yield horizontal line), yet the total returns index saw a commensurate increase in the interim, as was the case again in 2019.
We are unsure about the constructiveness of the new part of the Federal Reserve’s policy of extending its asset purchase program to include corporate bonds. The introduction of moral hazard seems unavoidable and risks altering the market-based mechanism of pricing good and bad debt accordingly. While this is an extraordinary measure resulting from an extraordinary situation, investors should not be discouraged by the prospect of negative yields while seeking safety and capital preservation.
*The oversimplified formula of total returns for bonds is:
Total Return = (Closing Price – Original Price) + Coupon Payments Therefrom.
The face value, or par value, of a bond will determine the capital that the investor will receive when the bonds mature. Therefore, if the bond was purchased at a price above par (at a premium) and if the bond was held to maturity, and the bond’s price continued creeping upwards until the end (when the bonds reached maturity), the investor will have incurred a loss in the price components of the formula above. Therefore, if held to maturity there will be a loss since the capital losses from the price components of the total returns equation will offset the gains from the “Coupon Payments Therefrom” part. If the bonds were purchased at a discount or at par, the price component will be positive, or at worst, zero.