Wednesday, July 13, 2016

Fixed income performance - It is all about duration - "Gimme that yield "

It has all been about duration in the Treasury market that has driven fixed income returns over the last year. It has not been about credit, albeit it has been on a wild ride. It has not been about diversification in developed and emerging market bonds although the declines in the developed world have been unprecedented. It certainly has not been about inflation protection, albeit it the returns for TIPS have not been bad. With SPY showing a 5.87 percent return for the last year, fixed income for anything beyond 5-year maturities have bested stocks. 

The long duration play has occurred in a world where the Fed has decided to hike rates. Inflation is stable to moving slightly higher, unemployment has moved below 5%, and 10-year yields have moved to multi-decade lows. A Taylor Rule model would suggest that rates should much higher, yet buying long bonds has been the big trade. 

The market could be telling us that a recession should be coming, but the the chances do not seem especially elevated. There could be a flight to safety  as evidenced by the strong Treasury showing the gains are especially concentrated on the long-end of the yield curve, but there has not been a corresponding increase of merit in the dollar. Perhaps the bets story is a shortage of high quality fixed income. In a search for yield, investor demand is significantly outstripping supply. Still, this is not what most would have expected a year ago. 

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