Battling Bond Vigilantes
High risk, high duration picks.
The move higher in the US Treasury yield curve over the past couple of months hasn’t gone unnoticed by many. Yet, the rise has presented some opportunities for fixed-income investors to lock in some perceived bargains further down the curve.
There has been good interest in some specific maturities, such as the 20yr Treasury strip, which costs an investor around $370k to get a face value of $1mm, with a yield of just over 5%.
In response, some will talk about the high duration risk, continued concerns of a bear market, high convexity and more. So today, we wanted to provide a breakdown of how to analyse and properly understand an outright long Treasury trade idea without the murky jargon.
Why Yields Have Moved Higher
Before we get onto the details, it’s worth first understanding why some might find the trade attractive.
US Treasury yields have ticked higher since late September. At the short end, we flagged the below chart in our ‘25 Charts For 25’ article. When isolating Fed Funds Futures pricing for 2025 (shown below via the Fed Funds spread between the Dec 24 and Dec 25 contracts), we can see that the market heads into the new year looking for 62bps worth of cuts. This materially changed from over 100bps priced back in September and is now tracking closer to the latest Fed dot plots:
The retracement of cuts expected for 2025 can be put down to several factors. The major one is a slight pivot from the Fed from their December meeting, where the dot plots (a guide on future interest rate movements) shifted. Fed officials now estimate that they’ll slash borrowing costs twice in 2025, half as many times as they previously estimated in September.
Economic data has also supported a move higher in yields, with headline CPI inflation showing indications it may have bottomed out in September. If investors feel that inflation will kick higher from here, monetary policy will likely need to be more restrictive to counteract this, hence higher short-term yields.
The victory of President-elect Trump in the US election in Q4 has given rise to concerns about inflationary pressures due to higher fiscal spending and trade policy measures. Although this is more of a speculative trade to have on, it’s certainly a factor at play (albeit more impacting the longer end of the curve).
Finally, we can’t ignore the impact of record bond supply that’s coming onto the market. This is needed as the US government’s budget deficit is currently running at 7.5 per cent of GDP. It’s the biggest debt burden relative to national income since at least the late 18th century.
Steve Russell from Ruffer shared the below chart recently with the caption:
“The IMF calculates that the net supply of bonds needing to be purchased by investors will be equivalent to more than 10 per cent of GDP this year, and for each of the subsequent five years. There is no comparable period outside wartime.”
The Long End of The Curve
When we talk about the long end of the curve, we’re referring to the yields on longer-term Treasury securities, typically those with maturities of more than 10 years.
These securities tend to be more sensitive to long-term growth, inflation, and interest rate trends.
A key way to measure the sensitivity of a bond to a change in interest rates is by looking at the duration of it. We’re not going to run through the CFA textbook here, but let’s run through the basics: