Yield is Destiny; Bonds are Back
By Robert Tipp, CFA, Chief Investment Strategist, Head of Global Bonds
Investing through the arc of the COVID recovery has hardly been a cakewalk, and the event horizon is hardly clearing as 2023 progresses. But as bond investors, we shouldn’t lose sight of the fact that bond yields have experienced a historic increase to what will likely prove to be generational highs. This is the positive side of last year’s market rout: with bonds, yield is more or less destiny. These higher yields should easily push bond returns in the coming decade well above those recorded over past decade (Figure 1).
As a result of the COVID recovery, markets have turned back the clock, pushing yields higher and setting bonds up for solid returns in the years ahead. After a recent rally amidst a series of bank failures, we believe long-term yields could drift slightly higher over the near term. In other words, regardless of the short-term movements, we remain at a strategic buying point for bonds.
Looking back over the decades, we can see that yields have passed through various paradigms, as indicated by the low, moderate, and high periods in Figure 2. Reviewing the factors that drove the transitions between outlier periods may give us some insight into where we are now, how we got here, and where we are headed.
The low yields of the Great Depression continued through the second World War as the Fed capped Treasury yields to facilitate government borrowing (Period II in Figure 2).
Most of the blame for rising rates in the 1970s is cast on the pre-Volcker Fed chiefs allowing inflation to get out of control. The 1980’s high, albeit falling, rates were regarded as the legacy of Fed Chairs Volcker and Greenspan waging and finishing the war on inflation.
Following a wave of fiscal consolidation in the U.S. and Europe, inflation from 2009 through 2020 fell to what central bankers deemed to be concerningly low levels of around 1.5% in the U.S. and 1% in Europe (Figure 4).
As a result of this inflation shortfall, central banks’ administered rates were kept at unusually low levels. In some cases, they were complemented by aggressive quantitative easing and low-rate lending programs, the combination of which drove developed market term structures to unnaturally low levels (Period IV of Figure 2).
The emergence from the COVID crisis provided two reasons for higher rates. The first was the booming growth and inflation. The combination of stimulus and reopening enthusiasm boosted demand, while supply remained muted due to a host of factors, including labor shortages and supply chain interruptions. The second “enabler” of higher rates, if you will, was the repaired damage from the GFC and its sluggish, debt-laden, Reinhart-and-Rogoff conditions.1 Consumer balance sheets and financial institutions’ capital positions were once again strong. That combination has resulted in surprising economic resilience. Hence, we should not be surprised to see the expansion continue despite the shift back to a higher range of interest rates (Period V of Figure 2).
So, where to for rates? Short-term outlook balanced …
The combination of significant hikes to date as well as signs that growth and inflation are beginning to moderate suggest that most of the rate hikes are behind us and that upside risk from current levels is limited. Should growth or inflation decline, however, the potential for a drop in rates would also seem limited given the high starting point for inflation and the low level of unemployment.
Near-term uncertainties notwithstanding, looking a few years into the future, it seems clear that given the demographic and productivity paths of most DM economies, the pace of growth and inflation will be lower.
In summary, the historic increase in long-term rates from the COVID lows to levels not seen for decades will provide a formidable tailwind for fixed income. After all, for bonds, yield is tantamount to destiny, and the recent explosion in yields has turned back the clock two decades, setting bonds up for strong returns in the decade ahead.
This material reflects the views of the authors as of December 20, 2022 and is provided for informational or educational purposes only. Source(s) of data (unless otherwise noted): PGIM Fixed Income.
1 Reinhart, Carmen M. and Rogoff, Kenneth S., “This Time is Different Eight Centuries of Financial Folly,” Princeton university Press, 2009.
For Professional Investors only. Past performance is not a guarantee or a reliable indicator of future results and an investment could lose value. All investments involve risk, including the possible loss of capital.
PGIM Fixed Income operates primarily through PGIM, Inc., a registered investment adviser under the U.S. Investment Advisers Act of 1940, as amended, and a Prudential Financial, Inc. (“PFI”) company. Registration as a registered investment adviser does not imply a certain level or skill or training. PGIM Fixed Income is headquartered in Newark, New Jersey and also includes the following businesses globally: (i) the public fixed income unit within PGIM Limited, located in London; (ii) PGIM Netherlands B.V., located in Amsterdam; (iii) PGIM Japan Co., Ltd. (“PGIM Japan”), located in Tokyo; (iv) the public fixed income unit within PGIM (Hong Kong) Ltd. located in Hong Kong; and (v) the public fixed income unit within PGIM (Singapore) Pte. Ltd., located in Singapore (“PGIM Singapore”). PFI of the United States is not affiliated in any manner with Prudential plc, incorporated in the United Kingdom or with Prudential Assurance Company, a subsidiary of M&G plc, incorporated in the United Kingdom. Prudential, PGIM, their respective logos, and the Rock symbol are service marks of PFI and its related entities, registered in many jurisdictions worldwide.
These materials are for informational or educational purposes only. The information is not intended as investment advice and is not a recommendation about managing or investing assets. In providing these materials, PGIM is not acting as your fiduciary. PGIM Fixed Income as a general matter provides services to qualified institutions, financial intermediaries and institutional investors. Investors seeking information regarding their particular investment needs should contact their own financial professional.
These materials represent the views and opinions of the author(s) regarding the economic conditions, asset classes, securities, issuers or financial instruments referenced herein. Distribution of this information to any person other than the person to whom it was originally delivered and to such person’s advisers is unauthorized, and any reproduction of these materials, in whole or in part, or the divulgence of any of the contents hereof, without prior consent of PGIM Fixed Income is prohibited. Certain information contained herein has been obtained from sources that PGIM Fixed Income believes to be reliable as of the date presented; however, PGIM Fixed Income cannot guarantee the accuracy of such information, assure its completeness, or warrant such information will not be changed. The information contained herein is current as of the date of issuance (or such earlier date as referenced herein) and is subject to change without notice. PGIM Fixed Income has no obligation to update any or all of such information; nor do we make any express or implied warranties or representations as to the completeness or accuracy. These materials are not intended as an offer or solicitation with respect to the purchase or sale of any security or other financial instrument or any investment management services and should not be used as the basis for any investment decision. PGIM Fixed Income and its affiliates may make investment decisions that are inconsistent with the recommendations or views expressed herein, including for proprietary accounts of PGIM Fixed Income or its affiliates.
In the United Kingdom, information is issued by PGIM Limited with registered office: Grand Buildings, 1-3 Strand, Trafalgar Square, London, WC2N 5HR. PGIM Limited is authorised and regulated by the Financial Conduct Authority (“FCA”) of the United Kingdom (Firm Reference Number 193418). In the European Economic Area (“EEA”), information is issued by PGIM Netherlands B.V., an entity authorised by the Autoriteit Financiële Markten (“AFM”) in the Netherlands and operating on the basis of a European passport. In certain EEA countries, information is, where permitted, presented by PGIM Limited in reliance of provisions, exemptions or licenses available to PGIM Limited under temporary permission arrangements following the exit of the United Kingdom from the European Union. These materials are issued by PGIM Limited and/or PGIM Netherlands B.V. to persons who are professional clients as defined under the rules of the FCA and/or to persons who are professional clients as defined in the relevant local implementation of Directive 2014/65/EU (MiFID II). In certain countries in Asia-Pacific, information is presented by PGIM (Singapore) Pte. Ltd., a Singapore investment manager registered with and licensed by the Monetary Authority of Singapore. In Japan, information is presented by PGIM Japan Co. Ltd., registered investment adviser with the Japanese Financial Services Agency. In South Korea, information is presented by PGIM, Inc., which is licensed to provide discretionary investment management services directly to South Korean investors. In Hong Kong, information is provided by PGIM (Hong Kong) Limited, a regulated entity with the Securities & Futures Commission in Hong Kong to professional investors as defined in Section 1 of Part 1 of Schedule 1 (paragraph (a) to (i) of the Securities and Futures Ordinance (Cap.571). In Australia, this information is presented by PGIM (Australia) Pty Ltd (“PGIM Australia”) for the general information of its “wholesale” customers (as defined in the Corporations Act 2001). PGIM Australia is a representative of PGIM Limited, which is exempt from the requirement to hold an Australian Financial Services License under the Australian Corporations Act 2001 in respect of financial services. PGIM Limited is exempt by virtue of its regulation by the FCA (Reg: 193418) under the laws of the United Kingdom and the application of ASIC Class Order 03/1099. The laws of the United Kingdom differ from Australian laws. In Canada, pursuant to the international adviser registration exemption in National Instrument 31-103, PGIM, Inc. is informing you that: (1) PGIM, Inc. is not registered in Canada and is advising you in reliance upon an exemption from the adviser registration requirement under National Instrument 31-103; (2) PGIM, Inc.’s jurisdiction of residence is New Jersey, U.S.A.; (3) there may be difficulty enforcing legal rights against PGIM, Inc. because it is resident outside of Canada and all or substantially all of its assets may be situated outside of Canada; and (4) the name and address of the agent for service of process of PGIM, Inc. in the applicable Provinces of Canada are as follows: in Québec: Borden Ladner Gervais LLP, 1000 de La Gauchetière Street West, Suite 900 Montréal, QC H3B 5H4; in British Columbia: Borden Ladner Gervais LLP, 1200 Waterfront Centre, 200 Burrard Street, Vancouver, BC V7X 1T2; in Ontario: Borden Ladner Gervais LLP, 22 Adelaide Street West, Suite 3400, Toronto, ON M5H 4E3; in Nova Scotia: Cox & Palmer, Q.C., 1100 Purdy’s Wharf Tower One, 1959 Upper Water Street, P.O. Box 2380 - Stn Central RPO, Halifax, NS B3J 3E5; in Alberta: Borden Ladner Gervais LLP, 530 Third Avenue S.W., Calgary, AB T2P R3.
© 2022 PFI and its related entities. 2022-8212