Why plunging Treasury yields are so alarming

March 5, 2020, 12:30 PM UTC

Just past 2 p.m. on Tuesday, Victoria Fernandez, chief market strategist at Crossmark Global Investments, was watching the 10-year Treasury make history. And wondering when people would realize how bad it was.

“It’s at .93,” she said as the yield dropped below 1% for the first time ever. “It’s starting to feed on itself,” she said. A moment later: “We’re now down at 11 basis points. It’s .91.”

The yield would eventually close the day at 1.02%. Technically the rate is still positive. If someone plans to buy a house, it means even lower mortgage rates, which key off the 10-year bond, are probably on their way.

But take inflation into account and the effective—or real—rates are negative. For the time being, and maybe the foreseeable future, the world of fixed income investment has turned upside down. Retirees, savers, insurance companies, pension funds, and others that depend on generating a return over time with little risk are facing a world where they are going to lose money.

Yields plunge

Yields on mid-range U.S. bonds like the 5-year, 7-year, and 10-year have wobbled since the financial crisis. As the graph below of nominal yields (not taking take inflation into account) shows, they’ve been dropping.

One reason is monetary policy. Central banks like the Federal Reserve, European Central Bank, and Bank of Japan pushed down the interest rates at which banks borrow money. The goal was to stimulate growth. The more liquidity there was in the system—the greater economic activity there would be, or so economic theory assumed.

Growth never took off. Japan and Europe have pushed interest rates below zero and held them down. The U.S. has continued to see above-zero, but historically low, rates.

Indeed, bond yields have been generally declining since 1981, when interest rates and inflation were in double digits and pushed rates to historical high points. Today, yields are lower than in the 1960s. The below graph shows what has happened to 10-year Treasury yields over time.

In an era where GDP is not growing like it once did, investors look for something they can count on, and U.S. Treasurys are top of the list—safe and paying more than other sovereign debt. Because yields move inversely from demand, the more parties looking to buy Treasurys, the lower the yields.

And that has brought one more complication.

Real negative yields

Yields on Treasurys have fallen so far that they are now below inflation rates. In real terms—subtracting inflation—the 5-, 7-, and 10-year Treasurys are in negative territory, as tracked by the Treasury Department.

The real yield of a 10-year as of Tuesday’s close was -0.43%. Someone buying a bond and holding it would lose principal over time. And when yields are low, people at or near retirement, pension funds, insurance companies, and others that need predictable and safe income are in trouble.

“This is certainly a brave new world where you’re lending money [by investing] … and it feels more like a borrowing transaction,” said Derek Klock, a professor of practice in the Department of Finance at Virginia Tech. “It’s topsy-turvy. You’re basically paying for safety.”

That can make sense in some circumstances. Last August, a complicated structure allowed a Danish bank to offer negative mortgage rates. Backing each mortgage, and taking the loss, was an institutional investor that needed a place to store money to meet future obligations. The negative rate for the pension fund was less of a loss than government bonds would have offered at the time.

Real negative rates are a problem for every person and institution that depends on a dependable and safe passive income from investments. “This is really a sad situation for retirees who are so dependent on the fixed income investments that they have,” Fernandez said.

“People have made money on rates going lower and lower and lower,” said Bruce Monrad, chairman and portfolio manager of Northeast Investors Trust. But the strategy depends on a continued drop so a previously purchased bond, even if negative in nominal or real terms, looks good in comparison to purchasing a new one.

The dynamic has changed fixed income investing from a ‘way to generate future revenues’ game and into a ‘bigger fool’ trading strategy. The investor profits from selling to the bigger fool that follows. At the moment, though, there’s little other choice.

“We’re frankly of the mind that most investors in debt securities, even though the Treasury pays them next to nothing, may be the only ones getting adequate returns for the risk they’re facing,” said Robert Phipps, director of wealth and capital management firm Per Stirling. At least the money is safe compared to other investments, such as equities and corporate bonds.

And that may be the mantra for today’s world. The new goal isn’t to make as much as possible, but to lose at little as you can.

This story has been updated to clarify some of the economic factors underpinning the drop in yields.

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—How companies like Ernst & Young are going to extremes to avoid infections
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