- Contrary to common wisdom, we show that low yields do not imply that US Treasury securities are expensive.
- After accounting for macroeconomic trends, Treasury bonds are only moderately overvalued.
- A proper valuation of the bond market requires going beyond simply blaming the Fed’s unprecedented policies of monetary easing.
- Given their recent negative correlation with stock returns, Treasury bonds may not be as unattractive as one might think.
In the frantic months following the fall of Lehman Brothers in 2008, the US Federal Reserve embarked on an unprecedented program of unconventional monetary policy easing. This program included purchases of mortgage-backed securities as well as Treasury bonds, and it continued until October 2014, well beyond most people’s expectations. The large degree of uncertainty associated with the effects of these policies logically led to a wide range of predictions from commentators and practitioners, including the downfall of the US dollar, rapidly rising inflation, and the build-up of a significant bubble in the Treasury bond market. These scenarios, albeit dramatic, were all reasonable possibilities within a highly uncertain economic evolution.
Ten years after the onset of financial troubles, the view of policy makers and investors has changed. On the shoulders of a moderate but persistent economic expansion, the US dollar has appreciated against major foreign currencies. Despite an unemployment rate at or below its natural level, core inflation has proven to be stubbornly low, forcing policy makers to reluctantly question their ability to influence prices (e.g., Cochrane, 2017). Yet this benign economic prognosis has hardly changed one belief: policies of easy money have pushed the Treasury bond market into bubble territory (e.g., Mooney, 2017).
One may be forgiven for blaming the Federal Reserve; given the long-lasting expansion, a 10-year Treasury note yielding just little above 2% does “feel” expensive. A notably slow process of policy normalization has failed to push long-term interest rates closer to their historical values. Moreover, the US stock market has also been on a multi-year run, which is inducing asset managers to speculate on the sustainability of current valuations across US capital markets.1 If a lower dividend yield is associated with expensive equities, then a lower bond yield should indicate expensive Treasuries.
In this article, we challenge the conventional wisdom. Different from equities, the empirical evidence shows that low Treasury yields do not necessarily imply expensive bonds. Indeed, our research shows that macro fundamentals are major drivers of real interest rates and largely explain the historically low yield environment. Whereas bonds do appear overvalued, we should not mistake a new normal of expected lower returns for a bond bubble. In addition, returns are not the only dimension that should determine an investor’s asset allocation. Bond and stock returns have been negatively correlated over the last 20 years, suggesting that in the future Treasuries could again offer a hedge against stock market fluctuations.
Rightly or wrongly, the Federal Reserve has been a favorite foe of many in the market place. Yet just as policy makers acknowledge the limits of monetary policy, so should investors. In relative terms, Treasury bonds are not as unattractive as one might think.
First Misconception: Low Yields Imply Expensive Bonds
In recent years, historically low yields have been interpreted as the manifestation of a bond bubble (e.g., Oyedele, 2017). Yet more than 50 years of empirical evidence indicates that this may be an unfounded conclusion.
We note that although bond yields forecast returns, they may be uninformative of bond valuations. To appreciate this insight, we rely on finance theory and decompose the returns earned from investing in a generic long-term bond into two building blocks—the short rate and the return in excess of this rate:
Total Bond Return = Short Rate + Excess Bond Return
Over the long run, the excess bond return represents the average risk premium earned from investing in a long-term security. For instance, purchasing a 10-year security and selling it after one year as a 9-year security is a riskier business than purchasing a security with exactly one year to maturity.2 Uncertainty regarding monetary policy decisions, the business cycle, and other potential risk factors can all affect the yield curve and lead to capital losses.
If a bond yield is a useful metric of a security’s over- or undervaluation, then this yield should be predictive of future excess return. In fact, higher expected excess returns are suggestive of an undervalued security, a situation likely to occur at times when investors are somewhat reluctant to hold long-term assets and thus are compensated with some extra return. Conversely, lower expected excess returns are indicative of an overvalued asset. Therefore, do yields forecast excess returns?
In an attempt to answer this question, we evaluate the predictive power of the 10-year yield using data from June 1961 through August 2017. Consistent with a tactical allocation exercise, we focus on short-term fluctuations and forecast the one-year return of the 10-year Treasury note. We find that the initial yield is indeed predictive of the security’s total returns, and this predictability becomes even more impressive over long horizons (e.g., Brightman, 2012). We also find that the yield is generally uninformative of the risk premium component of these returns. Historically, the level of yields has had little to say about the over- or undervaluation of a Treasury bond.