Last week, bond yields fell and prices rose, with 10-year U.S. Treasury yields hitting a one-month low of 2.1%.
While I still believe U.S. yields are likely to rise modestly by year’s end, last week’s decline in yields is a reminder that we’re in a “low-for-long” interest rate environment. This means that investors who are searching for income will continue to need to find alternative sources, as I write in my new weekly commentary, “Back to the Search for Yield.”
The recent drop in yields is a result of several factors. First, U.S. economic numbers continue to be mixed––an index of economic surprises is still hovering just above a six-year low––although the trend is toward improvement.
Second, inflation expectations are moderating after their recent surge. Investor expectations for U.S. inflation over the next decade fell to barely 1.8% on Friday from 1.95% in early May. The drop in inflation expectations has occurred at the same time as a resumption of the dollar’s rally and a stalling in the run-up in crude oil prices. The latter relationship is important. Inflation expectations followed oil higher for most of the spring. More recently, as oil prices have struggled with the prospect of U.S. shale production re-accelerating, inflation expectations have slid lower as well.
Given these forces, along with more structural considerations––aging populations, institutional demand for bonds and a dearth of supply––I expect that long-term yields will remain low even as the Federal Reserve (Fed) starts to raise rates. Short-term rates should rise, but long-term yields are likely to be more anchored over the next one to two years.
This leaves investors with the same challenge they’ve faced for the past five years: how to source yield in a low-yield environment. High yield bonds, which have outperformed the broader bond market year-to-date, could be a good option within fixed income.
Investors should also look to broaden their search for income beyond bonds. This suggests a greater emphasis on dividend-paying stocks, with an important caveat: Focus on dividend growth rather than the absolute level of yield. Many equity sectors offering high yields (such as utilities) are expensive and the most vulnerable to a rise in rates. Instead, yield-hungry investors can consider technology, financial, health care and select energy companies offering rising dividends.
Sources: Bloomberg, BlackRock