Treasuries take a licking but keep on ticking for investors

Amid rising inflation worries and expectations of additional interest rate hikes by the Federal Reserve, U.S. Treasuries have undergone a huge sell-off in recent weeks with no signs of reduced pressure ahead — but sources said there's still an important place for the embattled bonds in institutional portfolios.

The yield on the 10-year Treasury jumped to 2.32% as of March 31, up from 1.83% at the beginning of the month and up from 1.52% at the start of the year. Both increases were the largest since March 2019, according to S&P Global Market Intelligence. The 10-year Treasury yield has jumped even further this month, reaching 2.67% as of April 7.

The broad-based Bloomberg U.S. Aggregate Bond index, which includes Treasuries, government-related and corporate securities, mortgage-backed securities, asset-backed securities and collateralized mortgage-backed securities, fell 5.9% during the quarter ended March 31, the worst-performing quarter since the third quarter of 1980 when the index declined -6.6%. The Bloomberg U.S. Treasury index lost 5.6% in the first quarter, the worst performance since the index's inception in 1973.

Future Treasury performance could continue to face headwinds after the Fed in March passed a 25-basis-point rate hike, the first such increase since December 2018, and signaled at least six more rate hikes this year.

Treasury performance matters to institutional investors: According to the Securities Industry and Financial Markets Association, pension funds owned about 14% of the $25.7 trillion Treasury market at the end of 2021.

Despite the challenges facing Treasuries, some fixed-income specialists maintain that Treasuries should remain a core part of any investment portfolio, given their status as a safe haven and the diversification they provide. Moreover, they suggest some ways to mitigate risks in Treasuries by modestly reallocating to other fixed-income assets like investment-grade corporates and municipal bonds, among others.

Stephen H. Hooker, a Hartford. Conn.-based managing director and portfolio manager at multisector fixed-income shop Newfleet Asset Management LLC, cautioned that institutional investors are not likely to unload Treasuries during this period of high general market volatility, including volatility in interest rates, price and yield. However, he added, "We may see a small allocation shift, given our view of better relative value in investment-grade corporate bonds and municipal bonds, and higher return expectations for these sectors over the next year without taking on too much additional risk."

Newfleet has about $10 billion in assets under management, all in fixed income.

In the current environment, Mr. Hooker said he also favors fixed-income assets that have a low-to-negative correlation to Treasuries, such as bank loans and corporate high-yield bonds. "We also favor short-duration assets in sectors such as non-agency residential mortgage securities and asset-backed securities," he added.

For institutional investors seeking other fixed-income assets in addition to Treasuries, Anders Persson, the Charlotte, N.C.-based chief investment officer of global fixed income at Nuveen, said they might consider adding positions in sectors such as high-yield bonds, bank loans and preferred stocks, which produce more income while still providing lower volatility and downside protection.

Mr. Hooker said that while Fed policy continues to "become more hawkish in response to high inflation," the Treasury curve has already priced in the equivalent of at least eight rate hikes of 25 basis points each in 2022, including the one announced last month. "So, over the six remaining Fed meetings in 2022, the Fed is expected to raise the Fed funds rate by 50 basis points at one or more of these meetings."

But, he added, it is possible investors have already seen most of the weakness in Treasury prices if inflation starts to moderate over the remainder of this year.

Mr. Persson said he thinks the 10-year yield might reach 2.5% to 2.75% by year-end, thereby implying a "relatively modest move higher in yield from current levels and close to flat total returns."

Mr. Persson also contends that inflation is "likely peaking right around now," and assuming oil prices stay at current levels moving forward, he expects a total of 225 basis points of rate hikes by the Fed this year, including 50-basis-point moves at both the May and June meetings.

Even if this sell-off continues, Treasuries still have a place in institutional portfolios, Mr. Persson said.

"Treasuries historically have very low volatility," he said, meaning that the variance of their returns is low. "(Treasuries) rarely rally by a large amount in a short time, but they rarely sell off by a large amount as well," he explained. "Equities have much larger swings in both directions."

Since 2000, Mr, Persson pointed out, the standard deviation of monthly returns is about 1.3%, compared with about 1.6% for investment-grade corporates, 2.7% for high-yield bonds and 4.3% for equities.

Nuveen had a total AUM of $1.3 trillion as of Dec. 31, with fixed income accounting for $510 billion.

The war in Ukraine has also increased the volatility in Treasuries, Mr. Hooker noted.

"Initially the war caused a modest rally in Treasuries due to a flight to quality," he said. "However, as it became clear that the war was going to result in higher energy and food inflation as well as additional inflationary global supply chain issues, Treasuries resumed their downward performance trend."

Christoph Schon, the London-based senior principal of applied research at Qontigo, a Deutsche Boerse AG-owned financial intelligence, analytics and index provider, noted that the Russian invasion of Ukraine has "complicated things."

Before the conflict, central banks were expected to raise rates aggressively to keep long-term inflation expectations in check, Mr. Schon said. This led to a significant flattening of yield curves. "Now, there are two opposing forces pulling at long-term Treasury yields," he said. "The intensifying shortage in the energy and commodity markets is raising inflation expectations, putting upward pressure on yields, while safe-haven buying tends to depress them. If the latter prevails and central banks keep tightening monetary conditions in the face of soaring consumer prices, the U.S. Treasury curve could invert fully, with all short-term rates above long-term yields, which may be seen as a precursor of a recession."

Qontigo's clients collectively manage more than $10 trillion in assets.

However, David Sherman, the Pleasantville, N.Y.-based founder and portfolio manager of CrossingBridge Advisors, said that while Treasuries may be considered one of the safest investments in terms of credit risk, they nonetheless have a history of "having price volatility as a consequence of being a proxy for economic and market conditions."

CrossingBridge and its affiliate, Cohanzick Management, have $3.05 billion in AUM, the majority of which is held in fixed-income strategies.

Treasuries' status as a "safe haven" investment might be at some risk now, Mr. Schon cautioned. He indicated that for more than two decades, multiasset-class investors have relied on the inverse relationship between stock and bond prices for both portfolio diversification and downside protection in times of market turmoil.

"But the recent surge in commodity and consumer prices has triggered a simultaneous sell-off of (both) stocks and bonds," he said. "A further rise in inflation expectations is likely to intensify the co-movement of the two asset classes, and Treasuries may lose their utility as safe havens."

Eventually, Mr. Schon added, as yields continue to rise, "government bonds will start to look attractive again, especially once they approach or even surpass equity earnings yields." However, Mr. Schon noted that his firm's analysis suggests that the 10-year U.S. Treasury yield would have to rise above 4% for investors to see them as "viable alternatives to equities."