We have taken time to discuss the US Treasury yield curve in the past, but we wanted to take a moment to point out some of the issues currently infecting the broader fixed income market. Due to the pandemic and the intense market constriction earlier this year, the Federal Reserve needed to take action to make sure that there was liquidity in the market. They did an admirable job with that, injecting enough cash into the system to keep the gears of finance moving when everybody else was too scared to take a risk. What they have also done is to destroy (in the short term) the risk/reward interplay in the fixed income markets.
We are watching investors now comfortable with the Fed backstop for bonds move down farther on the risk spectrum in a desperate search for more yield.
We can see in the chart directly above that yields on investment grade US bonds went from 2.84% at the start of this year to 1.82% as of 11/27/2020 (Yield To Worst is the minimum yield that can be received on a bond, assuming no defaults). This is during a period when actual long-term risk to individual issuers has only increased, but yields have fallen -35% giving some investors a false sense of long-term security.
The chart directly above spans the last fifteen years. Looking at the data during the Global Financial Crisis of 2008, it took yields roughly a year to fall back to pre-crisis levels compared to the 2 months it took this year. This phenomenon extends to other sectors of the fixed income market. Junk (or high-yield corporate) bonds are issued by companies that generally have a higher risk of default than bonds issued by investment grade companies. In the chart below, we see that for this market sector things are back to where they started this year in terms of Yield To Worst.
There are deals to be had still in the fixed income market. But be careful because the going-forward risk may not be appropriately reflected in the yield of the bonds that are in the marketplace.