‘Rolldown’ Shows Why the Bond Market Is an Unfriendly Place to Hide

The absence of a ‘rolldown’ is making the U.S. bond market an unfriendly place for investors

By Richard Barley




HIGHER, FLATTER
U.S. Treasury yields

Source: FactSet



For bond investors, a concept called “rolldown” is like a virtuous form of financial gravity, a force that generates returns without doing much work. A flattening yield curve, however, is threatening the physics that investors rely upon.


Federal Reserve Chairman Jerome Powell speaks at a news conference following the Fed’s decision to raise rates. Photo: aaron p. bernstein/Reuters


The signals sent by the Federal Reserve Wednesday suggests the yield curve could flatten further: Its rate increases will raise short-dated yields, but there is still skepticism that rates in the long term will be materially higher.

When the yield curve is steep, investors benefit from the yield on a long-term bond “rolling down” the curve. As a 10-year bond over time becomes a nine-year bond, all else being equal, its yield falls and its price rises, producing a gain above the initial yield when the bond is purchased. That offers protection for bond investors in a rising-rate environment, notes TwentyFour Asset Management.



ROLLDOWN RETURN
Rolldown means an investor who holds a 10-year Treasury yielding 2.9% for a yearwould achieve higher returns the lower rates are at shorter maturities.


Source: Tradeweb


The U.S. yield curve still slopes upwards, with 10-year Treasurys yielding 0.57 percentage point more than two-year securities. But the further out you go, the flatter the curve gets. There is now only a 0.07 percentage-point gap between seven- and 10-year Treasury yields, a gap that has more than halved from a year ago. The potential for rolldown gains is small.

A similar phenomenon is showing up in U.S. corporate bond markets too, with the gap between short- and long-maturity bonds shrinking in both yield and spread terms. A number of forces are potentially at play here, as with the rise in Libor rates.


SQUEEZE
Yields on ICE BofAML U.S. corporate bond indexes

Source: FactSet



Higher U.S. Treasury bill issuance is competing for investors’ cash. And the pool of funding for short-dated debt may also have shrunk due to corporate cash repatriation, Citigroup suggests: if dollars can be repatriated and spent, they don’t need to be tied up in bond investments.

By contrast, steeper curves in eurozone government and corporate bond markets may make them attractive to investors. The European Central Bank’s negative-rate policy, which it is in no rush to change, is acting as an anchor for yields, reassuring bond investors. Coupled with the cost for foreign investors to hedge dollar-denominated bonds, U.S. bonds lose out despite their higher yields. All of that may lead to tighter U.S. financial conditions.


CURVEBALL
Gap between two-year and 10-year government bond yields


Source: FactSet



The absence of rolldown is just one factor in the investment equation, of course. But piled on top of a Fed that looks set to carry on raising rates and concerns about inflation, it makes the U.S. bond market an unfriendly place for investors.

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