Investors Are Worried About Government Spending. That’s No Reason to Avoid Bonds.

A recent jump in the yield on the 10-year Treasury note is one measure of the worsening sentiment around the U.S. debt load, says Noah Wise, a senior portfolio manager for the Plus Fixed Income team at Allspring Global Investments. Yields rose from 4% to 5% in the past three months, partly because of concerns about more Treasury issuance.

So, do rising yields mean investors shouldn’t buy bonds? Far from it. “Valuation, and psychological and technical factors, all are operating in concert and are all in the same direction right now,” Wise says.

Despite concerns about the size of the debt, longer-term bonds are attractive. “Before, we weren’t getting compensated for interest-rate exposure,” he says. “That has changed.”

Bond yields might rise even further, but the risk to investment portfolios is “asymmetric,” says Brian Barney, who oversees management and trading of institutional bond portfolios for Parametric Portfolio Associates. In other words, further increases in long-term rates would lead to small investment losses, while similarly sized decreases would lead to larger gains. (Bond prices move inversely to yields.) 

Yes, rising rates could dent economic growth, which would hurt stocks but also cool inflation. That is precisely the outcome the Federal Reserve has sought to achieve by raising short-term interest rates and reducing the bonds it holds on its balance sheet through a process known as quantitative tightening. When inflation falls further, long-term interest rates likely will fall, creating gains for bond investors.

Barney has been explaining this scenario lately to clients asking about projected deficits and growing federal debt. He makes a few additional points that he hopes will reassure them: “This isn’t a U.S. problem; it is affecting other developed countries,” he says of the high levels of government debt. 

Also, it is well known. The nonpartisan Congressional Budget Office issues regular reports on the federal budget, and its forecasts for increasing deficits and higher debt loads haven’t materially changed since last year, he says.

For now, the impending debt crisis, like the limitations of the Social Security trust fund, is more a slow-motion train wreck that will worsen before it is eventually dealt with in Washington. 

Can the market absorb higher amounts of U.S. government debt? So far, the answer is yes. Dynamics at some recent Treasury auctions have indicated weak demand, and market strategists are paying close attention to metrics like bid-to-cover ratios and the percentage of inventory that remains in the hands of bond dealers after an auction. But while foreign governments are purchasing fewer Treasuries, other buyers, such as pension funds, have stepped in. “There is demand at these higher yields,” Barney says.

If geopolitical tensions worsen, more investors likely will flee to the safety of U.S. Treasuries. Pershing Square’s Bill Ackman, whose vocal worries about U.S. fiscal health helped to drive down bond prices, said he recently covered his short positions due to concerns about global risk. His disclosure sparked a mini rally in Treasuries this past week.  

U.S. debt is still safer than almost any other income-producing security on the planet, and that gives it an important role in portfolios, especially during market shocks. Fitch downgraded its U.S. credit rating by one notch in August, not because the U.S. isn’t able to repay its debt, but because political dysfunction likely will make it harder to find a long-term solution to escalating debt levels. 

When the fiscal health of the U.S. starts to become a worry globally, a major tell will be a decline in the U.S. dollar, which has risen against other currencies since the summer.

A crisis isn’t inevitable. “As long as debt is productive and used for investments that can grow more than the cost of debt, then we’ll end at a good place,” says Barney of the longer-term outlook. 

Near term, Vanguard puts the case for bonds succinctly. In a recent report, the firm wrote, “Bond investors are likely to be better off because of—not despite—the recent bond selloff.”

Federal debt levels might be scary, but higher rates make government bonds your friend, not your enemy.

Write to Amey Stone at [email protected]