Core Equity: Q3 2022
The Fed: Will Skyrocketing Bond Yields Influence the Economy?
Key Points
- Bond yields been hovering at levels not seen since 2007.
- Term premium is the compensation that investors require for bearing the risk that interest rates may change over the life of the bond.
- Supply and the increased term premium are not the only factor impacting bond yields; demand has changed.
- The higher long-term yields are restrictive to economic growth, something the Fed wants.
The new “monkey wrench” of possible factors influencing the economy’s trajectory is the rapid rise of long-term interest rates. The benchmark ten-year Treasury note currently yields 4.5%. In the past few weeks, it has been hovering at levels not seen since 2007. There are many theories for this rapid upward movement in yield, which include Fed Chair Jerome Powell’s press conference following the September FOMC meeting with the Fed’s improved outlook for a more vigorous pace of growth. The other is the massive $2.2 trillion increase in Treasury debt since June, when the debt ceiling was extended. Bond investors are growing concerned about the quasi-infinite deficit spending.
Chart 1: 10-Year Treasury Note
%, yield to maturity
Source: Bloomberg, October 2023
The yield on a long-term bond is based on what investors think short-term interest rates will average over that period plus something called term premium. The Fed defines this as “the compensation that investors require for bearing the risk that interest rates may change over the life of the bond.” That compensation can be driven by many factors, such as expected inflation or, in this case, the fear of massive supply that the market cannot easily absorb, pushing yield up higher.
Supply and increased term premium are not the only factors impacting bond yields; demand has changed. For more than a year, the Fed has stopped buying bonds under its quantitative easing policy, and it is now letting Treasury bonds mature out of its portfolio in its quantitative tightening policy. Since May 2022, when Treasury holdings hit a peak of $5.8 trillion, the Fed has allowed $860 billion mature without reinvesting. This means the Treasury needs to find another buyer of its debt. With fewer buyers, there is more supply. Prices go down, and yields go up.
The higher long-term yields are restrictive to economic growth, something the Fed wants. It is another factor consistent with our belief that the Fed will not need to raise interest rates at its next meeting on December 13.
Chart 2: Fed Treasury Bond Portfolio - Monthly Change
$, billions
Source: Federal Reserve, October 2023
Information is subject to change and is not a guarantee of future results.
Important Information
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Index Definitions
S&P 500 Index: The S&P 500 Index, or Standard & Poor’s 500 Index, is a market-capitalization-weighted index of 500 leading publicly traded companies in the US It is not an exact list of the top 500 US companies by market cap because there are other criteria that the index includes.
Bloomberg Barclays US Aggregate Bond Index (LBUSTRUU): The Bloomberg Aggregate Bond Index or “the Agg” is a broad-based fixed-income index used by bond traders and the managers of mutual funds and exchange-traded funds (ETFs) as a benchmark to measure their relative performance.
GT10: US Government Treasury Yield
Bloomberg Municipal Bond Index: The Bloomberg US Municipal Bond Index measures the performance of investment grade, US dollar-denominated, long-term tax-exempt bonds.
Bloomberg Municipal High Yield Bond Index: The Bloomberg Municipal High Yield Bond Index measures the performance of non-investment grade, US dollar-denominated, and non-rated, tax-exempt bonds.
S&P Leveraged Loan Indexes (S&P LL indexes) are capitalization-weighted syndicated loan indexes based upon market weightings, spreads and interest payments. The S&P/LSTA Leveraged Loan 100 Index (LL100) dates back to 2002 and is a daily tradable index for the US market that seeks to mirror the market-weighted performance of the largest institutional leveraged loans, as determined by criteria. Its ticker on Bloomberg is SPBDLLB.
Bloomberg US Corporate Bond Index: The Bloomberg Barclays US Corporate Bond Index measures the investment grade, fixed-rate, taxable corporate bond market. It includes USD-denominated securities publicly issued by US and non-US industrial, utility and financial issuers.
Bloomberg US High Yield Index: The Bloomberg US Corporate High Yield Index measures the performance of non-investment grade, US dollar-denominated, fixed-rate, taxable corporate bonds.
Bloomberg: LF98TRUU Index: The Bloomberg US Corporate High Yield Bond Index measures the USD-denominated, high yield, fixed-rate corporate bond market. Securities are classified as high yield if the middle rating of Moody’s, Fitch and S&P is Ba1/BB+/BB+ or below. Bonds from issuers with an emerging markets country of risk, based on Bloomberg EM country definition, are excluded. This is the total return index level.
Morningstar SPBDLLY Index: Yield to maturity time series of the Morningstar LSTA US Leveraged Loan 100 Index. The Morningstar LSTA US Leveraged Loan Index is a market-value weighted index designed to measure the performance of the US leveraged loan market.
Bloomberg Investment Grade Index: The Bloomberg US Investment Grade Corporate Bond Index measures the performance of investment grade, corporate, fixed-rate bonds with maturities of one year or more.
Bloomberg Municipal Bond Index: measures the performance of investment grade, US dollar denominated, long term tax exempt bonds. Bloomberg US Treasury Index: includes all publicly issued, U.S. Treasury securities that are rated investment grade, and have $250 million or more of outstanding face value.
Investment Grade (IG) Municipal Bond Index: The Bloomberg US Municipal Bond Index measures the performance of investment grade, US dollar-denominated, long-term tax-exempt bonds.
High Yield (HY) Municipal Bond Index: The Bloomberg Municipal High Yield Bond Index measures the performance of non-investment grade, US dollar-denominated, and non-rated, tax-exempt bonds.
Definitions
Yield to Worst (YTW) is the lower of the yield to maturity or the yield to call. It is essentially the lowest potential rate of return for a bond, excluding delinquency or default.
P/E Ratio: The price-to-earnings ratio (P/E ratio) is the ratio for valuing a company that measures its current share price relative to its earnings per share (EPS).
City National Rochdale Proprietary Quality Ranking formula: 40% Dupont Quality (return on equity adjusted by debt levels), 15% Earnings Stability (volatility of earnings), 15% Revenue Stability (volatility of revenue), 15% Cash Earnings Quality (cash flow vs. net income of company) 15% Balance Sheet Quality (fundamental strength of balance sheet).
*Source: City National Rochdale proprietary ranking system utilizing MSCI and FactSet data. **Rank is a percentile ranking approach whereby 100 is the highest possible score and 1 is the lowest. The City National Rochdale Core compares the weighted average holdings of the strategy to the companies in the S&P 500 on a sector basis. As of September 30, 2022. City National Rochdale proprietary ranking system utilizing MSCI and FactSet data.
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