It’s hard to miss that there has been a pronounced slowdown in the U.S. economy this year. While I expect U.S. economic growth to re-accelerate in the second quarter and the Federal Reserve (Fed) to hike interest rates this fall, long-term rates are likely to remain muted.
In other words, as I write in my new weekly commentary, the quest for yield will remain challenging, reinforcing the case for considering high yield within a fixed income portfolio.
Part of the recent soft U.S. growth is admittedly a function of two temporary factors: a brutally cold winter and the West Coast port strike. That said, it’s worth reiterating how much economic numbers have disappointed of late. U.S. economic surprises continue to run at the most negative level since 2009, recent manufacturing reports have come in weak and March’s payroll gains were 126,000, below even the most pessimistic expectations. Although I continue to believe the underlying fundamentals of the labor market remain strong, first quarter gross domestic product is likely to disappoint.
Against this backdrop, it shouldn’t be surprising that bond yields remain low. This downward trend has been exacerbated by foreign central bank bond buying and a dearth of new supply.
But low U.S. yields are also a function of even lower yields outside the United States. Currently, 25% of the European sovereign bond market is trading with a negative yield. In France, government bonds of up to three years carry a negative yield. In Germany, it is eight years, and in Switzerland, 10 years. In this context, a U.S. 10-year bond offering a roughly 2% yield and, backed by a strong currency, actually seems appealing.
If Fed liftoff does occur this fall as I expect, it’s most likely to manifest in what is referred to as a flattening of the yield curve. In other words, we are likely to see a greater lift in shorter-term interest rates, with a less substantial rise in long-term rates.
So what does this mean for investors? With rates stuck near historic lows, investors are left searching for income wherever they can find it. High yield is one segment of the bond market they could consider. In recent weeks, the spread (or difference) between the yield of the 10-year Treasury and a high yield bond of comparable maturity actually widened a bit, roughly 0.45%, restoring some value in the space.