Bond investors want to be paid for waiting again

The benchmark ten-year US Treasury yield pushed through 4.25 per cent in late October 2022, its highest since 2008, and with it bond investors have started asking to be paid for waiting again. For more than a decade the bond market lived under financial repression so heavy that investors routinely accepted negative real returns for the privilege of holding government paper. The term premium, the extra return demanded for holding a ten-year bond instead of rolling over short-term bills, all but disappeared from the conversation. Amid quantitative easing and explicit forward guidance, duration was treated as if it carried no risk. That complacency is over.

The jump in long-dated yields cannot be explained only by changing expectations for the federal funds rate. The short end of the curve has priced in a higher peak for policy rates, but the steepening further out reflects a bigger shift in the term premium. When the recent rise in yields is broken down with standard affine term-structure models, such as the Adrian-Crump-Moench model run by the New York Fed, it shows investors across the world repricing duration risk.

Splitting the yield

An affine model divides a ten-year yield into two parts. One is the expected path of short-term policy rates over the next decade. The other is the term premium that investors demand for inflation uncertainty and volatility, among other risks. Through 2020 and 2021 the estimated term premium on ten-year Treasuries was well below zero, at one point reaching minus 100 basis points. Investors were in effect paying the US Treasury for the convenience of holding duration.

That premium is now climbing back towards positive territory, for several reasons. The first is that volatile inflation has damaged government bonds' value as a hedge. For twenty years bonds could be relied on to rise when shares fell, because stock and bond prices moved in opposite directions. In 2022 inflation shocks have pushed down equity valuations and bond prices together, the correlation has turned sharply positive, the classic 60/40 portfolio has suffered badly, and investors now want an explicit extra return for holding duration.

The negative premium of the past decade was itself unusual. In the early 1980s, after a decade in which inflation had repeatedly surprised upwards, model estimates of the ten-year term premium ran to several percentage points. Investors who had been burned by rising prices demanded protection against being burned again, and that protection took years to erode as inflation stayed down. A premium that merely climbs back above zero would still be modest by the standards of that era.

Fewer buyers, more bonds

The second reason is that supply and demand for Treasuries have fallen out of balance. The Federal Reserve, once the least price-sensitive buyer in the market, is shrinking its balance sheet and letting up to $60 billion of Treasuries roll off each month. Foreign central banks, the main overseas buyers, are also stepping back, and Japan is selling Treasuries to pay for its currency intervention. Commercial banks are sitting on big unrealised losses on their securities and are in no position to buy more duration.

With the price-insensitive buyers in retreat, each extra Treasury note has to be sold to private fund managers and hedge funds. These buyers care a great deal about funding costs and financing spreads. They will not take down quarterly refunding auctions worth hundreds of billions out of civic duty, and they want a wide term premium to protect themselves against future rate swings and bigger deficits.

The strain shows in the plumbing. Dealers' balance sheets have not grown in step with the stock of Treasuries outstanding, so they have less room to warehouse bonds when clients sell, and market depth has thinned this year. The Treasury secretary, Janet Yellen, said this month that she was worried about a loss of adequate liquidity in the market. A thinner market needs a higher premium to persuade anyone to stand in front of large trades.

Lessons from 2013 and 1994

The two most recent term-premium shocks show how quickly the repricing can happen. In 1994 the Fed began raising rates from 3 per cent, and long yields rose far more than the expected path of policy justified, as investors who had crowded into duration all tried to leave at once. In 2013 Ben Bernanke merely mentioned slowing the Fed's bond purchases, and the ten-year yield rose from about 1.6 per cent in May to around 3 per cent by September, with most of the move attributed to the term premium. Both episodes began with a central bank changing how much duration it was willing to hold, which is what quantitative tightening does now.

Who pays the premium

The repricing reaches every borrower who prices off the long end. The average rate on a 30-year fixed mortgage is close to 7 per cent, its highest since 2002, and home sales have slumped accordingly. Real yields on ten-year inflation-protected Treasuries have climbed above 1.5 per cent from well below zero at the start of the year, which squeezes the valuations of growth shares whose profits lie far in the future. Savers, pension funds and insurers are the gainers: they can lock in positive real returns for the first time in more than a decade.

The case against a durable rise is that a recession would reverse it. When growth falls, investors flee into government bonds, the correlation with shares turns negative again and the premium compresses, and the curve between two and ten years is already inverted, a sign that markets expect rate cuts eventually. Model estimates of the premium also differ from one another by wide margins. Even so, a recession that cuts short rates would not undo the shrinking of the Fed's balance sheet or the size of the deficits, which are the structural reasons the premium was negative and is not any longer.

The Fed's decision on 2 November and the Treasury's quarterly refunding announcement, due at the start of November, will show how much duration the market is being asked to absorb. The return of the term premium raises the hurdle rate for capital around the world. With the risk-free ten-year rate now carrying a positive premium, owners of commercial property and corporate credit will have to mark their assets to higher discount rates over the coming year. Ten-year Treasuries yielding above 4 per cent look less like an aberration than a return to historical norms, in which waiting for money finally costs something, and the heaviest markdowns will fall on office buildings and other property bought with cheap long-term debt.