Risk, But Not Much Reward

With higher yields and shorter durations, Agency bonds represent better value than U.S. Treasurys in 2016.

March 17, 2016

This sector report is excerpted from the First Quarter 2016 Fixed-Income Outlook.

After rising to 2.5 percent in June 2015, 10-year Treasury yields fell below 2 percent in the first quarter of 2016 as inflation expectations declined. Ten-year breakeven rates—a measure of inflation expectations calculated from the difference in yields on nominal and inflation-protected bonds—dropped to 1.2 percent in February, and have since bounced back with the rebound in oil. Although slower to adjust than the market, the Fed has become increasingly dovish with every release of its Summary of Economic Projections. A year ago, the Fed projected that the fed funds target rate would be at 3.75 percent by 2017. In the Fed’s latest projection, that forecast dropped to 2.4 percent.

10-Year Breakeven Rate Signals Lower Inflation Outlook

Falling inflation expectations have been one of the main catalysts behind rate volatility and falling U.S. rates in 2015. 10-year breakeven rates, a measure of inflation expectations from the difference in yields of nominal and inflationprotected bonds, have declined to 1.4 percent, reflecting investors’ expectations that the Fed will be unable to achieve its inflation target.

10-Year Breakeven Rate Signals Lower Inflation Outlook

Source: Bloomberg, Guggenheim. Data as of 2.29.2016.

In terms of overall sector performance, the Barclays U.S. Treasury index posted a positive 0.8 percent return in 2015, with intermediate 3–5 year Treasurys outperforming shorter- and longer -dated Treasurys. Agency debt, as measured by the Barclays U.S. Agencies index, lost 0.4 percent for the year. Longer-dated callable Agency bonds, an area of focus for Guggenheim, returned 3.4 percent in 2015. Their relatively strong performance was driven by a lack of long-end callable Agency supply and a decline in volatility.

Analysis by our Macroeconomic Research Team suggests that U.S. Treasury rates have the potential to move even lower, although working against this trend is a technical imbalance from lower projected issuance and selling by foreign central banks. As of December 2015, the trailing 12-month net selling of U.S. Treasurys by foreign officials reached $226 billion, the largest net sales total over a 12-month period on record. If net selling accelerates, Agency bonds may represent better value relative to Treasurys. Many Federal Farm Credit and Federal Home Loan Bank callable Agency bonds trade at 120–140 basis points over 10-year Treasurys at yields of approximately 3.25 percent, but carry lower option-adjusted durations. Lower rates make us increasingly cautious over callable Agency bonds trading at a premium because the holder of a called bond must reinvest the incoming cash at a potentially lower yield. While supply is often limited, we prefer discounted callable Agency bonds, because their lower coupon means lower call risk. Additionally, we find value in longer-dated Agency strip securities that trade cheap to their whole bond, as this spread should compress as the yield curve flattens.

Median FOMC Expectations of Future Fed Funds Rate Reflect Dovishness

Although slower to adjust than the market, the Fed has become increasingly dovish with every release of its Summary of Economic Projections. A year ago, the Fed projected that the Fed funds target rate would be at 3.75 percent by 2017, based on median projections. This figure has since dropped to 2.4 percent and may fall further.

Median FOMC Expectations of Future Fed Funds Rate Reflect Dovishness

Source: Federal Reserve, Guggenheim. Data as of 12.31.2015.

—Connie Fischer, Senior Managing Director; Tad Nygren, CFA, Director; Kris Dorr, Director

Important Notices and Disclosures

This article is distributed for informational purposes only and should not be considered as investing advice or a recommendation of any particular security, strategy or investment product. It contains opinions of the authors but not necessarily those of Guggenheim Partners or its subsidiaries. The authors’ opinions are subject to change without notice. Information contained herein has been obtained from sources believed to be reliable, but are not assured as to accuracy. Past performance is no guarantee of future results.

Investing involves risk. In general, the value of fixed-income securities fall when interest rates rise. High-yield securities present more liquidity and credit risk than investment-grade bonds and may be subject to greater volatility. Asset-backed securities, including mortgage-backed securities, may have structures that make their reaction to interest rates and other factors difficult to predict, making their prices volatile and they are subject to liquidity risk. Investments in floating-rate senior-secured syndicated bank loans and other floating-rate securities involve special types of risks, including credit risk, interest-rate risk, liquidity risk and prepayment risk.

Guggenheim Investments represents the following affiliated investment management businesses of Guggenheim Partners, LLC: Guggenheim Partners Investment Management, LLC, Security Investors, LLC, Guggenheim Funds Investment Advisors, LLC, Guggenheim Funds Distributors, LLC, Guggenheim Real Estate, LLC, Transparent Value Advisors, LLC, GS GAMMA Advisors, LLC, Guggenheim Partners Europe Limited and Guggenheim Partners India Management.


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