The appeal of longer bonds

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Good morning. Bank of America, reporting second-quarter results yesterday, drove home the message sent by other large banks last week: credit quality is still fine, the consumer is still fine, interest rate margins are still fine. The shares rose 4 per cent, and the whole sector rallied. Note, however, that bank stocks still have not approached the levels that prevailed before the banking micro-crisis in March. I’m not sure if that makes sense or not. Send me your thoughts: robert.armstrong@ft.com

Longer bonds

At various points in the past year or two, Unhedged has noted the appeal of owning bonds at the short end of the curve. As the Fed had increased rates, the short end offers a chance to get some meaty returns and then reassess things in just a year or two when the smoke, literal and figurative, has cleared. That argument looks as strong now as it ever has. One-year Treasury yields are above 5 per cent. Inflation, depending how you measure it, is 3 per cent-ish. With stocks not looking terribly cheap, why not take your 2 per cent after-inflation return and see what the equity market offers in the summer of 2024?

It seems to me, however, that the improving inflation outlook increases the appeal of the long end of the curve, too. The 10-year Treasury yield has not moved much since the autumn of last year, but the inflation situation is both clearer and more benign. Rates volatility appears to be easing off. If we are one the way back to normal after a bout of supply-shock inflation, then locking in a 3.8 per cent yield for 10 years — when pre-pandemic long yields were quite consistently below 3 — seems like a logical bet.

None of this is to suggest I know something the bond market doesn’t. If long yields have not fallen much as the news on inflation has improved, there is a reason for that. But the basic thought seemed worth exploring. So (being fundamentally a stocks guy) I got in touch with my favourite fixed-income people and asked as simple question: is duration risk becoming more attractive?

“Yes it is. Bought US 10s around 4 per cent so enjoying some returns.” That’s Scott DiMaggio, co-head of fixed income at AllianceBernstein. He was, presumably, too busy earning money to add much detail. Jim Sarni of Payden & Rygel, made his argument more explicit: “investors are better off being smart than lucky.” That is to say, investors who need income should lock in yields in the middle of the curve — five years or thereabouts — without worrying about whether they are getting peak yields. “The risk of being too short is greater than the risk of being too long. If cash flow is important to you, you might not see these yields again. You need to lock some of that in.”

Dec Mullarkey of SLC Management agrees: 

It’s certainly getting close to an environment where duration can generate gains. The positive tone for both headline and core inflation and a Fed that is about to settle close to its terminal rate are all constructive for extending duration. With real rates still close to a post GFC high and inflation cooling, the Fed should have room for sizeable rate cuts next year to support trend-like growth.

The argument against adding duration is equally simple, though: lower inflation and, to an extent, falling rates are already largely priced into the market. The futures markets anticipates more than six quarter-point rate cuts by January of 2025. Five-year inflation break-evens have been parked near 2 per cent for several months now. The inverted yield curve also indicates that falling rates are priced in. Bond yields can’t be expected to fall much when what is expected to happen happens. 

“The curve already prices in a decent fall in rates and spreads are just normal to slightly tight so you aren’t locking in anything special — either for rates or for spread,” Greg Obenshain, who manages corporate bonds at Verdad Capital, told me. Unhedged’s regular interlocutor Ed Al-Hussainy, of Columbia Threadneedle, agrees that deflation is largely priced in, but he is long 5- 7-year bonds all the same. A real yield of 2 per cent on a 5-year “is not a bad starting point,” he says. He is worried, though, that the battle against inflation is not quite won, which makes it hard to bet aggressively against the short end of the curve: 

I’m a bit nervous here. The odds that the fed funds rate exceeds 5.25-5.5 per cent by the end of the year are around 25 per cent. The Fed would have to revise their inflation forecast lower to justify this pricing. We’re not quite there yet.

Thomas Tzitzouris of Strategas also frets that inflation is not dead yet and adds, furthermore, that bets on higher bond prices at the long end have to contend with the fact that the Fed is still shrinking its balance sheet — increasing the supply of long-duration assets. Further relaxation of the Bank of Japan’s yield curve control program could pull money out of the US bond market, too. He’s cautious. 

I keep coming back to Sarni’s point, though: trying to be smart rather than lucky. We don’t know how close we are to the end of inflation and the peak of rates, but we know we are close. We don’t know where yields are going, but we know that is better to invest at significant positive real yields than at the near- or below-zero real yields that have predominated for so long. Adding a little duration makes solid sense. 

One good read

A great interview with Joyce Carol Oates: “You suddenly realise that the human experience is going to be your experience. When that starts to happen to you, it is quite stunning.”