Looking Beyond Negative Yields

Steve Boothe, Portfolio Manager

Executive Summary

  • We believe that bonds will continue to provide benefits in terms of both portfolio diversification and return in the years ahead.
  • However, with absolute bond yields at low or even negative levels in some markets, these benefits may be muted relative to historical patterns.
  • These dynamics heighten the need to take an active, global approach to a fixed income allocation that can provide opportunities to gain additional yield.

Bonds will continue to provide benefits in terms of both portfolio diversification and return in the years ahead, in our opinion. However, with absolute bond yields at low or even negative levels in some markets, we acknowledge that these benefits may be muted relative to historical patterns. These dynamics heighten the need to take an active, global approach to a fixed income allocation. Investors can diversify their bond allocations across regions and segments that provide opportunities to benefit from the total return potential of international or emerging markets or from the additional yield from currency hedges. From a broader asset allocation perspective, we believe bonds still provide an attractive source of diversification against equity market downturns.

Opening Quote …a negative return on a bond with a negative yield is only guaranteed if an investor holds the bond to maturity. Closing Quote

Accommodative Monetary Policies Likely to Continue

Years of negative benchmark lending rates and aggressive quantitative easing policies from the Bank of Japan and the European Central Bank have driven yields on high‑quality Japanese and eurozone government debt—and some corporate bonds—well into negative territory. We see little sign that these accommodative monetary policies will change in the foreseeable future, making it increasingly difficult for fixed income investors to generate income. However, we do not anticipate that the U.S. Federal Reserve would implement negative rates.

Of course, a negative return on a bond with a negative yield is only guaranteed if an investor holds the bond to maturity. While it is possible that yields could become even more negative, providing opportunities for price appreciation by selling a bond before it matures, we believe it is more prudent to seek to generate total return in more efficient ways.

Opening Quote …we expect a fixed income allocation to provide a useful hedge against a future downturn in stocks. Closing Quote

Opportunities to Diversify Outside Government Bonds

One potential source of return from bonds is carry,1 which measures incremental yield. From a broad asset allocation perspective, carry becomes particularly important when equity markets are not following clear upward or downward trends. To find bonds with more potential for carry, investors can look to securitized debt such as mortgage‑ and asset‑backed securities, which typically offer higher coupons than Treasuries. Corporate bonds provide attractive coupons and carry along with higher credit risk, making fundamental credit analysis vital. Bank loans, which have noninvestment‑grade credit ratings but receive repayment priority over bonds in the event of issuer default, are a market that has expanded meaningfully in recent years and can generate attractive carry.

Corporate bonds from issuers in developed international and emerging markets can also offer beneficial carry. Issuance of emerging markets bonds has grown meaningfully in recent years, providing more potential opportunities in a market that has also become higher quality. In addition, hedging the currency exposure in non‑U.S. dollar‑denominated bonds back to dollars can generate additional yield. This hedged yield results from the difference in short‑term yields between non‑U.S. currencies—short‑term rates are very low in euros, for example—and U.S. dollar short‑term rates.

Bond Allocations Continue to Provide Diversification

While the income available from bonds has fallen with global yields, we believe that a core bond allocation will continue to be an attractive source of diversification against a bear market in equities. The rolling 12‑month returns for the Bloomberg Barclays U.S. Aggregate Bond Index were negatively correlated with the returns of the S&P 500 Index during the eurozone debt crisis in 2012 and 2013, during the global financial crisis in 2007 and 2008, and in the early 2000s after the bursting of the dot‑com stock bubble.2

Bonds continue to benefit during periods of risk aversion, so we expect a fixed income allocation to provide a useful hedge against a future downturn in stocks. With equity valuations at elevated levels relative to historical averages, our expectations for stock returns are muted, potentially making this diversification even more valuable.

Active Management Essential on Many Levels

Active portfolio management is an essential component of an effective fixed income allocation. This can take the form of fundamental credit analysis to inform security selection, which is particularly important in segments that provide higher carry. Another form of active portfolio management involves tactical allocation to bonds in non‑core segments such as emerging markets. At the broadest level, multi‑asset portfolio managers can help optimize an investor’s allocations across asset classes based on an economic outlook and tolerance for risk.

What we're watching next

Heathy consumer spending has underpinned the U.S. economy in 2019 as manufacturing has shown continuing signs of weakness, weighing on corporate capital expenditures. With the Fed seeming unlikely to cut rates further in the near term, we are closely monitoring consumer sentiment surveys to evaluate whether consumers will maintain their spending pace and support the economy.

 Carry is a bond’s coupon minus the cost of cash financing.

2 Sources: Bloomberg Index Services Limited and S&P/Haver Analytics (see Additional Disclosures).


Additional Disclosures

Bloomberg Index Services Limited. BLOOMBERG® is a trademark and service mark of Bloomberg Finance L.P. and its affiliates (collectively “Bloomberg”). BARCLAYS® is a trademark and service mark of Barclays Bank Plc (collectively with its affiliates, “Barclays”), used under license. Bloomberg or Bloomberg’s licensors, including Barclays, own all proprietary rights in the Bloomberg Barclays Indices. Neither Bloomberg nor Barclays approves or endorses this material, or guarantees the accuracy or completeness of any information herein, or makes any warranty, express or implied, as to the results to be obtained therefrom and, to the maximum extent allowed by law, neither shall have any liability or responsibility for injury or damages arising in connection therewith.

Copyright © 2019, S&P Global Market Intelligence (and its affiliates, as applicable). Reproduction of any information, data or material, including ratings (“Content”) in any form is prohibited except with the prior written permission of the relevant party. Such party, its affiliates and suppliers (“Content Providers”) do not guarantee the accuracy, adequacy, completeness, timeliness or availability of any Content and are not responsible for any errors or omissions (negligent or otherwise), regardless of the cause, or for the results obtained from the use of such Content. In no event shall Content Providers be liable for any damages, costs, expenses, legal fees, or losses (including lost income or lost profit and opportunity costs) in connection with any use of the Content. A reference to a particular investment or security, a rating or any observation concerning an investment that is part of the Content is not a recommendation to buy, sell or hold such investment or security, does not address the suitability of an investment or security and should not be relied on as investment advice. Credit ratings are statements of opinions and are not statements of fact.



This material is being furnished for general informational purposes only. The material does not constitute or undertake to give advice of any nature, including fiduciary investment advice, and prospective investors are recommended to seek independent legal, financial and tax advice before making any investment decision. T. Rowe Price group of companies including T. Rowe Price Associates, Inc. and/or its affiliates receive revenue from T. Rowe Price investment products and services. Past performance is not a reliable indicator of future performance. The value of an investment and any income from it can go down as well as up. Investors may get back less than the amount invested.

The material does not constitute a distribution, an offer, an invitation, a personal or general recommendation or solicitation to sell or buy any securities in any jurisdiction or to conduct any particular investment activity. The material has not been reviewed by any regulatory authority in any jurisdiction.

Information and opinions presented have been obtained or derived from sources believed to be reliable and current; however, we cannot guarantee the sources' accuracy or completeness. There is no guarantee that any forecasts made will come to pass. The views contained herein are as of the date noted on the material and are subject to change without notice; these views may differ from those of other T. Rowe Price group companies and/or associates. Under no circumstances should the material, in whole or in part, be copied or redistributed without consent from T. Rowe Price.

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