(PUB) Vanguard Advisor

A LOT OF INK has been spilled recently asking why bond yields have declined this year and almost as much explain- ing why they’re bound to begin rising. The one question that hasn’t been asked is why everyone believes yields have to head significantly higher. At the start of 2014 everyone “knew” that bond yields were headed higher, but the year hasn’t played out that way. The yield on the benchmark 10-year Treasury is currently trading around 2.52%, but in late May, it threatened to dip below 2.40%. This is a substantial decline from its year-ending 3.03%. Earning 2.5% or so for the next 10 years doesn’t sound all that good on its own—at least not to my ears. So what’s driving demand? When 2.5% Is Sumptuous Depending on your objectives and alternatives, the 2.5% yield on the 10-year U.S. Treasury actually looks pretty darn good, particularly when you compare it to other top-ranked sover- eigns around the globe. The chart below plots a number of 10-year sovereign bond yields with those from developed markets in dark blue, emerging markets in light blue and the U.S. in black. Note that the 10-year Treasury yields more than bonds from many of what you and I would think of as strong, developed market economies, including Germany, Japan, France and Canada. Even bonds from previously BONDS Yields in Context

troubled European countries like Spain and Italy now yield less than 3%, so while you may pick up a hair more yield there, it comes with a heaping dose of risk. Even the emerging mar- kets don’t offer great advantages, with several countries’ bonds sporting yields below 4%. Add in the fact that the U.S. Treasury market is the deepest and most liquid of any securities market in the world, and that Treasurys are the flight-to-safety asset of choice, and a yield of 2.5% suddenly doesn’t look half bad. That’s particularly true if you have to buy bonds—and there are plenty of people that do, such as mutual fund and pen- sion managers. Theresultofthisisthat Intermediate- Term Treasury ’s SEC yield of 1.55%—not to mention Total Bond Market ’s 2.00% yield—looks attrac- tive compared to Total International Bond ’s 1.30% yield. But aren’t rates poised to rocket higher as we enter a new bear market for bonds? What’s Behind Door #3? Looking to history as a guide, the chart below is the standard view of the 10-year Treasury yield that most bond investors are familiar with since regular bond auctions began in the early ’60s. In essence, it appears that bond yields have either been on one grand sweep

History of Range-Bound Rates

10% 12% 14% 16%

0% 2% 4% 6% 8%

5/29

5/34

5/39

5/44

5/49

5/54

5/59

5/64

5/69

5/74

5/79

5/84

5/89

5/94

5/99

5/04

5/09

5/14

Source: Ibbotson

higher (a bear market for bonds) or a long ratcheting down (a bull market for bonds). But isn’t there a third option—a sideways, range-bound environment? Well, if we step back and extend our view even further, as I do in the chart above tracking long-term U.S.

That 2.5% yield on the 10-year U.S. Treasury actually looks pretty darn good, particularly when you compare it to other sovereigns.

Government bond yields back to 1926, you can see that there is precedent for interest rates to be range-bound. For nearly four decades from the mid- 1920s to the mid-1960s, yields were range-bound between 2% and 4%. It has been five years or so since the 10-year Treasury’s yield dropped below 4%. Could we be five years into yet another range-bound market? It’s possible. Or maybe the past five months have just been a pause in a slow grind higher in rates. We won’t know until it’s over, but just because rates are low today doesn’t mean a sharp, sustained move higher and a steep decline in bond prices are coming tomorrow. n

10-YearYieldsNearTheir Lows

10-YearYieldsAcross theGlobe

6%

10% 12% 14% 16% 18%

Developed Markets Emerging Markets

5%

4%

3%

2%

0% 2% 4% 6% 8%

1%

0%

Canada U.S.

U.K.

Italy

Spain

Japan

Netherlands France

Brazil (USD) Greece

Sweden

Portugal

Switzerland Germany

Mexico (USD) Australia

South Korea

4/64

4/69

4/74

4/79

4/84

4/89

4/94

4/99

4/04

4/09

4/14

Colombia (USD)

Source: Bloomberg

Source: Bloomberg

The Independent Adviser for Vanguard Investors • July 2014 • 13

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