CIO INSIGHTS
FO U RTH Q UARTER 2016 – FIXED I N CO M E
Yields Are Low. Spreads Are Narrow. What Could
Change, and When?
Bond investors have enjoyed an extended run of positive performance. Because
it’s been our experience that markets are inherently self-correcting, we’re
weighing bond market risks as yields stay low and credit spreads1 stay narrow.
What could change, and when?
Our CIO Insights Introduction piece
this quarter (“Global Political, Emotional
Undertones Contributing to Unusual Market
Behavior”) discusses the unusual global
conditions that have simultaneously pushed
the yields of U.S. Treasuries2 and high-yield
corporate bonds3 lower and U.S. stock
prices higher.
These simultaneous bond and equity rallies
were largely generated by the following
two factors:
1.Extraordinary monetary stimulus programs
by central banks around the world.
2.Relentless demand for yield—investors
buying anything with higher yields, including
high-yield corporate securities, asset- and
mortgage-backed securities,4 and longermaturity U.S. Treasury securities.
Risk assessment and risk management
are critical parts of our active investment
management process. We watch the
markets and bond issuers carefully to assess
whether portfolio positions are adequately
compensated for risk and how liquid they are
if we want/need to exit them.
As government bond yields around the world
continue to hover near all-time lows, and
credit spreads stay narrow, our Global Macro
Strategy and Risk Management teams are
constantly asking: How and when could these
conditions change? And, what’s more likely to
change, interest rates or credit spreads?
Let’s look first at why interest rates are low.
The answers are primarily fundamental/
economic. Economic growth in the world’s
developed economies remains weak and
vulnerable, with the full impact of Brexit (the
United Kingdom’s vote to exit the European
Union) yet to be determined. In July, the
International Monetary Fund estimated that
the world’s advanced economies would grow
just 1.8% in 2016 and 2017, motivating the
world’s central banks to continue aggressive
IN-FLY-90785 1609
stimulus programs. Rates are also low
because of low global inflation, reflecting
the influences of China’s lower growth and
demand, lower energy prices, other reduced
commodities prices, and a stronger U.S.
dollar. Low growth + low inflation = low
interest rates.
Next, let’s examine why credit spreads
narrowed. The reasons are more technical
than fundamental, based on supply and
demand. While the economic and financial
fundamentals for credit sectors are OK,
strong investor demand for yield was the
primary narrowing factor recently. Two other
key factors involved the U.S. stock market.
First was year-to-date (through August 31)
stock performance—when equities perform
well, credit spread sectors also tend to
perform relatively well. Second was low
equity market volatility after Brexit, which we
think gave investors confidence to chase
higher yields.
So, our risk assessment boils down
to: What’s more likely to change, the
fundamentals for low interest rates, or the
technicals and sentiment for narrow credit
spreads? We don’t foresee big changes in
either area in the near term, but we think the
balance of risks leans toward credit spreads
widening, especially if equity market volatility
increases from August’s very low levels.
What if the Federal Reserve (Fed) raises
interest rates? That would provide another
reason for spreads to widen. But we don’t
think the Fed is likely to move until at least
December because of low global inflation
and the uncertainties surrounding global
growth, Brexit, and the U.S. election. And if
it does move, the rate increase(s) would be
small, U.S. short-term rates would still be low
and stimulative, and we believe longer-term
rates would remain largely suppressed by
global fundamentals, demand, and the low
yields of non-U.S. bonds.
©2016 American Century Proprietary Holdings, Inc. All rights reserved.
G. David MacEwen
Co-Chief Investment Officer
“Risk assessment and risk
management are critical
parts of our active investment
management process.”
Spreads refer to yield differences. Credit spreads
refer to yield differences between lower- and
higher-quality securities of the same maturity in
sectors, such as corporates, mortgages, assetbacked, and municipals.
1
U.S. Treasury securities are debt securities issued
by the U.S. Treasury and backed by the direct “full
faith and credit” pledge of the U.S. government.
2
High-yield corporate bonds are higher-risk,
high-yielding taxable bonds comprised of debt
instruments from corporations rated below BBB
by Standard & Poor’s.
3
Mortgage-backed securities are a form of
securitized debt that represents ownership in
pools of mortgage loans and their payments.
4
Generally, as interest rates rise, bond values
will decline. The opposite is true when
interest rates decline.
The opinions expressed are those of
G. David MacEwen and are no guarantee
of the future performance of any American
Century Investments portfolio.
For educational use only. This information is
not intended to serve as investment advice.
Non-FDIC Insured • May Lose Value • No Bank Guarantee