By Daniel Kruger
This year's global debt rally has left some investors wondering if the biggest gains are in the rearview mirror.
U.S. government debt has returned 7.8% this year through Thursday counting price changes and interest payments -- well above the 2.2% average for the previous 10 years, according to Bloomberg Barclays data. This year's 13% gain in corporate bonds for that period is more than twice the 6.1% average since 2009, while high-yield debt has appreciated 11%, roughly matching its 12% annual average for the same period. The S&P 500 is up 17% for that period.
Now, some investors are concerned that bond prices have risen so much that they have little room to increase further. Boosted by an unusual combination of steady economic growth and Federal Reserve rate cuts, the yield on the benchmark 10-year Treasury note -- the percentage investors expect to earn annually from buying the bonds -- now stands around 1.7%, within 0.4 percentage point of its all-time low. Yields fall when prices rise.
At the same time, the extra yield investors demand to hold both investment- and speculative-grade corporate debt instead of relatively safe Treasurys stands near multiyear lows.
For Treasurys to notch further gains, the economy will likely have to show new signs of deceleration, some investors say. That could hit corporate and junk bonds, which investors tend to sell in times of economic weakness. The reverse is also true: A surge in growth that boosts corporate bonds would likely dent gains in Treasurys.
"This is the quandary for taxable [bond] investors like ourselves," said Bryce Doty, a bond manager at Sit Investments. "I've been telling my customers this just isn't sustainable."
Recession worries and interest-rate cuts from the Fed have boosted bonds of all kinds this year. But worries that the gains can't go on forever have led some investors to unusual corners of the market. Mr. Doty said he has added taxable bonds sold by states and local governments, which offer more attractive yields and stronger credit quality than most company debt or the tax-exempt bonds typically sold by municipalities.
Investors say they are also worried that a slowdown in global growth caused by rising trade tensions could lead to a contraction in corporate profits. Analysts expect earnings for companies in the S&P 500 to fall about 4% for the third quarter, according to FactSet data, in what would mark the biggest quarterly year-over-year drop since 2016.
Even with default rates well below historic averages, falling profits could push investors to demand higher yields on corporate bonds, eroding some of the recent gains. And some investors said the strength and duration of the rally make it hard to tell which bonds in what sectors of the economy will hold their value in a selloff.
"You can't look at the market and say, ooh, this is a good value," said Nancy Davis, chief investment officer at Quadratic Capital Management. Ms. Davis manages an exchange-traded fund, the Quadratic Interest Rate Volatility and Inflation Hedge ETF.
The fund, which invests in Treasury securities whose returns are indexed to inflation and bets on how bond prices will swing as expectations for Fed interest rates change, has gained 2.3% since its inception about five months ago. Ms. Davis expects bigger gains as returns on government and corporate debt stall.
Some investors also worry that a surge of economic optimism could hurt both government and corporate bonds. That is because an improved outlook could lead investors to sell holdings of safe government bonds, driving prices down for them as well as for the debt of the safest companies.
"We've had such strong performance this year, you have to temper expectations about what future returns will be," said Kathy Jones, chief fixed-income strategist at the Schwab Center for Financial Research, a unit of Charles Schwab Corp.
Many individual investors have taken that sentiment to heart.
With an investment in fixed-income assets, investors typically "don't expect much in terms of its return potential, but we know it keeps us safe," said Patrick Rush, chief executive officer at Triad Financial Advisors Inc.
Write to Daniel Kruger at Daniel.Kruger@wsj.com
(END) Dow Jones Newswires
October 14, 2019 08:14 ET (12:14 GMT)
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