US Treasury bonds as high yield securities

Tom Traill - 11 January 2018

If the yield on a government bond can be read as an indication of the perceived risk of holding the asset – both the risk of default, and the risk of inflation eroding the value of the bond, then one might expect the US to sit near the top of the tree, as indeed it did until 2012. Barring some technical (debt-ceiling-related) disruption to the ability of US government to honour its obligations, surely Treasury debt is risk-free? As for inflation risk, the investment community remains supremely confident that the US problem is too little inflation rather than too much. So why is the US 10-year bond trading on a yield so much higher than many other developed economies?

Looking at the 60 countries for which we have consistent 10-year yield data, the US has slipped into the lower half of the table. Portugal, which was among the world’s highest yielding bonds in 2012, now has a lower yield than the US (figure 1), with some help from Draghi’s “whatever it takes”, along the way. Croatia, South Korea and Hungary are the latest additions to the list of sovereigns with lower benchmark yields than America. Australia and New Zealand are next in line to undercut the US yield.

While the ratings agencies seldom change their view on sovereign debt, this ranking of 10-year yields offers an alternative take on market perceptions of creditworthiness. In absolute terms, there is a persuasive argument that some of the nations with the lowest bond yields are trading at ridiculously low levels – even negative in the case of Switzerland – thanks to the bombardment of liquidity from the ECB and Bank of Japan. Yet, even after making reasonable allowance for this distortion, the rankings would be unaltered. 

The popular view is to consider the widening US bond spread in a ‘carry’ framework: this implies that the US currency becomes more attractive as the carry increases. A contrary approach is to regard the widening spread as an expanding sovereign risk premium. The world has never been so invested in US assets, as captured by the net International Investment Position (NIIP) (figure 2), which was highlighted in the Financial Times last week. If US domestic assets have become over-owned by overseas investors, softening Treasury bond prices constitute a currency sell signal, rather than the opposite.

If a growing NIIP shortfall signifies a loss of control over one’s destiny, then this might lead to further US Dollar weakness or further upward pressure on bond yields. US equities, representing a claim on global assets, are better placed to withstand US portfolio capital outflow than US Treasury debt. Despite the recent US interest rate rises at the short end of the yield curve, the US Dollar has languished, and there are early indications of yield curve steepening in 2018.  How much further down the league table can Treasuries descend?

Figure 1

Data source: Thomson Reuters Datastream

Figure 2

Data source: FRED, St Louis Federal Reserve

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