For the first time in nearly a generation, fixed income is living up to its name.
This, at a certain level, is simply the consequence of benchmark rates in the US jumping from 0% to over 5% in a span of two years.
But at a time when all of Wall Street seems fixated on whether the Federal Reserve will actually cut interest rates this year — and heated arguments break out over whether the 10-year US bond should yield, say, 4.5% or 4.65% — it’s easy to lose sight of one important fact: That after being held hostage by zero-rate policies for almost two decades, US Treasuries are finally reverting back to their traditional role in the economy.
That is, as a source of income that investors can lock in and rely on, year after year, for years to come — regardless of where yields are at any given moment.
The numbers tell the story. Last year, investors pocketed nearly $900 billion in annual interest from US government debt, double the average over the previous decade. That’s set to rise as over 90% of Treasuries carry coupons of 4% or more. In mid-2020, just 5% yielded that much. Because of the higher interest, investors are also better shielded against any jump in yields. Currently, rates would need to go up by over three-quarters of a percentage point over the next year before Treasuries start to lose money, at least on paper.
Over the past decade, that margin of safety at times virtually disappeared.1
“With the help of our friends at the Fed, they did put the income back in fixed income,” said Anne Walsh, who oversees about $320 billion as chief investment officer of Guggenheim Partners Investment Management. “And fixed-income investors, we get to reap the benefits of higher yield. That’s a good thing.”
Two recent economic trends have worked in their favor.
First is that, while inflation is tantalizingly close to the point where the Fed might consider cutting rates, lately, progress toward its 2% goal has stalled. That’s pushed out rate-cut expectations into at least the latter part of the year.
Second, and perhaps more importantly, is simply that the economy keeps humming along (despite some signs of cooling in the labor market), which suggests the Fed won’t need to lower rates all that much when it does begin.
Fed Chair Jerome Powell underscored that wait-and-see approach in his remarks last week after the central bank held rates steady, while the traders currently see just two quarter-point cuts by year-end. At the start of the year, they priced in as many as six.
“Nobody is focused anymore on what could go wrong if the wheels come off with the economy,” said Blake Gwinn, head of US interest-rate strategy at RBC Capital Markets. “And every month that goes by is another month that a cut didn’t happen.”
As a result, safe assets like Treasuries — from one-month T-bills to 30-year bonds — now have something to offer anyone looking for income.
Money, Money, Money
In February, the Congressional Budget Office projected that interest and dividends paid to individuals will rise to $327 billion this year — more than double the amount in the mid-2010s — and keep increasing each year over the coming decade. In March alone, the Treasury Department paid out about $89 billion in interest to debt holders — or roughly $2 million a minute.
It’s no small irony that the newfound income from Treasuries may itself be playing a role in keeping the “higher-for-longer” narrative intact. A small, but growing number on Wall Street argue that, along with the surge in stock prices, the interest paid on Treasuries and other bond investments is creating a material wealth effect among Americans, with the extra cash acting like stimulus checks supporting the surprisingly resilient economy.
Of course, the whole point of owning US government bonds is that they aren’t supposed to lose money, are less volatile than equities and will provide a fixed rate of return above inflation. There’s no sugar-coating the fact that the very reason Treasuries are back in demand as a buy-and-hold option — after years of yielding next to nothing — is because of brutal losses in recent years in the face of rampant inflation and the aggressive rate hikes to combat it.
That reset, however painful, has now paved the way for higher future returns and a “more normal” fixed-income market.
Investors have responded by piling in. Money-market funds — which invest in short-term securities like T-bills — saw their assets swell to a record $6.1 trillion last month. Meanwhile, bond funds raked in $300 billion in 2023 and $191 billion so far this year, reversing outflows in 2022 that were the biggest in recent memory, according to EPFR data. Direct sales of Treasuries to individuals have jumped, too.
All told, the amount of debt held by households and non-profits has surged 90% since the start of 2022 to a record $5.7 trillion, according to Fed statistics.
Dan Ivascyn, chief investment officer at Pacific Investment Management Co., says the reset in yields for high-quality debt of all kinds, from Treasuries to corporate bonds, will have broad implications for the buyout firms, hedge-fund managers and private-credit shops that drew in hundreds of billions of dollars when rates were at rock-bottom lows.
Back to the Future
He also noted that bonds are now a “tremendous value” versus stocks. By one measure, known as the Fed model, they’re more attractive versus US equities than at any time since 2002.2
“We’re seeing far more inquiries for fixed income than we’ve seen in the last almost 15 years,” Ivascyn said. Investors are asking themselves “why am I making it so complicated when I can get 6, 7, 8% from bonds? So it’s opening up a whole new buyer base.”
There is, of course, no certainty this will stay the case. But there are solid reasons to believe that yields won’t revert back to their post-financial-crisis levels even after the Fed starts cutting rates. That means fixed income will likely remain in demand.
For starters, nagging worries about inflation, fueled in part by trends like the de-globalization of supply chains, will likely keep rates from falling too far as investors demand protection against the risk their income will be eaten away by the rising cost of living. After accounting for inflation, yields are now back above 2%. The last time that happened on a sustained basis was prior to the 2008 financial crisis.
Then, there’s the massive US deficit, which is all but certain to be financed by a never-ending supply of new bonds. Not only is that likely to keep yields elevated, but it will also provide a burgeoning source of interest income for bond investors, month after month.
“It seems like going back to the future — a little bit back to some normal times,’’ said Matt Eagan, a money manager at Loomis Sayles & Co., which oversees roughly $350 billion. “It’s quite a big turnaround.”
1 Estimate based on the duration of the Bloomberg Treasury index, which includes securities across the maturity spectrum. Figures for individual securities will vary.
2 Fed model is a valuation tool that compares the earnings yield for S&P 500 companies to the yield on 10-year Treasuries
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