Fixed-income securities have had an extraordinary run, but don t call it a bubble

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1 Wells Fargo Advantage Funds January 2011 Fixed-income securities have had an extraordinary run, but don t call it a bubble Jim Kochan, Chief Fixed-Income Strategist Jim Fuson, CFA Christopher Kennedy Wells Fargo Funds Management, LLC It is tempting to look at the nearly two-year-long rally in U.S. fixed-income securities and think that it must end badly. Common wisdom knows that when yields go up, bond prices go down, and since yields are exceptionally low, they must go up at some point. Although this simple adage is true, it is only a small part of the current story. Yes, U.S. Treasury (UST) yields are low and long-term UST yields have fluctuated in recent months, but yields are not dislocated from their historical fundamental valuations given the current economic and inflationary environment. Current real yields on 10-year USTs are reasonable on a historical basis, which is one of many reasons why we believe it is inaccurate to call current fixedincome markets an asset price bubble. In this paper we define what a bubble is and demonstrate how current fixed-income markets do not fit the definition of a bubble. We measure the current fundamental valuations of long-term USTs and we review the low-yield environment, the steepness of the yield curve, the effects of low inflation, and the prospects for extended periods of highly accommodative monetary policy. IN THIS REPORT Defining a bubble Measuring the fundamental values of the bond market Rates may remain low for a while Conclusion

2 Defining a bubble For a bubble to occur in an asset class, certain characteristics typically apply: a. Investors have unrealistic expectations for future price appreciation. b. Asset prices rise far above their fundamental valuations. c. High levels of leverage typically support speculative buying and inflated prices. We saw all three of these characteristics in the tech bubble of 2000 and the housing market bubble of In the tech bubble, equity prices became dislocated from fundamental valuations, often pricing in outrageous growth assumptions into perpetuity. Investors continued buying those stocks not on fundamentals but on the belief that they would continue to return 40% or more a year because that s what they returned in the previous year and the year before, etc. Similar outrageous assumptions were priced into the housing bubble as investors assumed that houses would appreciate by at least 20% a year because that s what they had done for each of the previous four years. In both cases, high levels of leverage contributed to rampant speculation. The bubbles popped because the speculative values had far exceeded fundamental valuations. By contrast, none of the above characteristics of a bubble currently apply to the fixedincome markets. One would be hard-pressed to find a current investor in U.S. Treasuries who is speculating on significant future price appreciation, rather than just trying to protect capital and earn a reasonable yield. In fact, the rally in bonds is not about irrational exuberance, as one typically finds in an asset bubble, but rather the exact opposite a sober and cautious response to limited opportunities for investment returns in an environment of low growth and low inflation. Further to the point, current fundamental valuations of U.S. Treasuries, measured by their real yields (nominal yield minus inflation), are not dislocated from their historical averages. The exceptional conditions of the current bond markets are less about bonds themselves and more about the exceptional conditions of the U.S. economy and inflation. In our opinion, bond markets appear to be responding appropriately to current conditions and have neither excessively deviated from their historical fundamental values, nor reached nominal lows that we have not experienced before. 2

3 Measuring the fundamental values of the bond market Current nominal yields on U.S. Treasuries are low, but they have been this low, and even lower, before (Chart 1). From 1930 through 1953 the average nominal yield on the long-term U.S. Treasury composite* was 2.66%; the average real yield was only 0.43% during that period. During much of the 1940s, 10-year UST notes often had yields of less than 2.00%, persisting in the 1.60% range during the middle of the decade. Thus, 10-year UST yields from the 1930s, 1940s, and first half of the 1950s make today s 10-year nominal yield of 3.29% seem generous by comparison. But current-day investors likely have the paradigm of the last 50 years in mind when they measure today s yields. The average 10-year UST yield was much higher at 6.36% from 1954 through 2010, peaking at 15.80% in We have become accustomed to a higher yield environment but low yields are not uncommon, nor are they alone indicative of a dislocation in fixed-income asset pricing. Real yields are a good measure of fundamental value in the UST market. If one were only looking at a line chart of historical real yields of USTs (Chart 2 on page four) and plotted today s current real yields, he or she would not notice anything out of the ordinary. As of December 31, 2010, the real yield (nominal yield minus inflation) on the 10-year U.S. Treasury note was 2.19% (3.29% minus 1.10% Consumer Price Index year over year), which is below the chart 1 Nominal Long-Term* and 10-Year U.S. Treasury Yields Yields (%) Sources: St. Louis Federal Reserve; , long-term UST composite; , 10-year composite *Long-term composite includes all UST maturities longer than 10 years from Record of 10-year only composite begins in April 1953 by the Federal Reserve. Past performance is no guarantee of future results. 3

4 Measuring the fundamental values of the bond market average real yield from the period of 2.56% but well within one standard deviation* of its average. Real yields on 10-year USTs could go as low as 0.29% and still be statistically within one standard deviation of their historical average. But further to the point, low real yields are typical for low growth expectations and not inappropriate for today s economic conditions of tepid GDP growth, weak housing markets, high unemployment, and low borrowing demand. The recent real yield on the 10-year UST is both reflective of current low growth conditions and also statistically well within range of its historical average. The measure that is currently most out of alignment is inflation, which is at its lowest level since the 1950s. Bond yields are merely pricing in both the current monetary accommodation and the exceptionally low levels of inflation. Similar conditions have occurred before and corresponding levels of nominal yields and real yields have accompanied them. A long-term shift in economic conditions, monetary policy, and inflation expectations will likely be the trigger that alters the current levels of nominal yield, not a collapse of speculative asset pricing as one would find in an asset bubble. chart 2 Real 10-Year U.S. Treasury Yields (UST Yield - CPI YOY%) Year UST Real Yields 8.0 Average Real Yield Yields (%) Upper Standard Deviation Lower Standard Deviation Sources: St. Louis Federal Reserve; 10-year UST composite Consumer Price Index for All Urban Consumers Past performance is no guarantee of future results. *Standard deviation of return measures the average deviations of a return series from its mean, and is often used as a measure of risk. 4

5 Rates may remain low for a while Someday rates will rise. But that day may be further off than many investors think. Current market sentiment appears to believe that short-term rates will stay extraordinarily low through at least the first half of It is not out of the question for them to stay low for even longer. As previously discussed, low yields persisted for more than two decades during the 1930s and 1940s and lingered mostly within the 2.0% 3.0% range through the first half of the 1950s. Thus, 10-year note yields in the 2.5% 3.5% range, as we have seen recently, are not unprecedented. With current inflation levels around 1.0%, as they were in the 1950s, it is not uncharacteristic to see UST yields also drop to the low levels set during that period. Any rate increase from the Fed would be unlikely until we get a significant increase in inflation. Until then, 1950s-style nominal yields could persist. Other factors to consider are the huge demand for USTs and the dearth of private credit growth. With its latest round of quantitative easing (QE2), the Fed intends to buy approximately $600 billion in USTs from November through June 2011, at a pace of $75 billion a month. Add to that massive demand from foreign investors, particularly currencypegged nations such as China, and indications are that the $500 billion of projected supply of 10-year and longer maturities over the next 12 months could be outstripped by foreign and central bank demand, keeping yields within their current ranges. This relative scarcity of USTs also drives investors seeking adequate returns into other fixed-income asset classes, thus driving credit spreads narrower. Certainly the Fed s massive buildup of bank reserves through UST purchases is something to monitor going forward, but so far these actions have not translated into credit expansion, money supply expansion, or increased inflation, and there are few indications that these effects will take form anytime soon. When economic and inflationary conditions shift, the Fed will likely draw down those reserves and slowly raise rates. But until these conditions begin to manifest, bond yields will likely continue to remain nominally low. A final consideration is the steepness of the yield curve. As of December 31, 2010, the yield on the three-month Treasury bill was 0.12%, compared with the 10-year note yield of 3.29%. A gradual shift in monetary policy that increases short-term rates would not necessarily equate to a sharp rise in long-term bond yields. Markets recently went through just such a scenario. From 2004 through 2006 the Fed steadily raised the federal funds rate a quarter of a point 5

6 Rates may remain low for a while a month, from 1.00% in April 2004 to 5.25% in June Rather than seeing the curve shift higher in parallel with the rise in shortterm rates, the curve flattened, with the front end of the curve shifting higher while yields of 10 years and longer remained relatively unchanged (Chart 3). In fact, the 30-year UST bond s yield actually declined by 10 basis points during the period. The same pattern of flattening occurred in the municipal bond market. No one can be certain of how a rising rate environment would affect the yield curve, but it is far too pessimistic and simplistic to presume that rising federal funds rates necessitate large losses in longer-durated assets. Massive shifts in long-term yields typically play out over longer time horizons; thus, avoiding the long end of the curve may cause an investor to miss out on higher levels of yield during periods of low interest rates or slowly rising short-term rates. chart 3 During the Rising Rate Environment the UST Curve Flattened Yields (%) Month 6-Month 2-Year 3-Year 5-Year 10-Year 30-Year Source: Bloomberg The yield curve is a graphical representation of fixed income security yields (usually U.S. Treasuries) at their respective maturities, starting with the shortest time to maturity and sequentially plotting in a line chart to the longest maturity. The yield curve is based on historical performance and does not represent future results. 6

7 Conclusion The current fixed-income landscape looks quite different from that of the last 50 years, but that doesn t mean it s irrational. When people say that bonds are overvalued today, they are typically assuming that investors will require a higher yield in the near future, not that the bond s ability to generate return on investment is gone. While it may be true that future investors could require a higher yield, that does not mean that the bonds are overvalued for today s growth and inflation conditions or for the various potential scenarios that may or may not develop in the upcoming quarters or years ahead. Historical precedence appears to indicate that recent prices and yields on U.S. Treasuries are not dislocated from fundamental valuations and do not fit the definition of an asset price bubble. Given current inflationary and economic conditions, bond valuations appear reasonable, and staying invested in bonds at these ranges of real yield is still an appropriate investment consideration. 7

8 Strength. Expertise. Partnership. Wells Fargo Advantage Funds skillfully guides institutions, financial advisors, and individuals through the investment terrain to help them reach their financial objectives. Everything we do on behalf of our investors is built on the standards of integrity and service established by our parent company, Wells Fargo & Company; the expertise of our independent investment teams and rigorous ongoing investment review; and the collaborative level of superior service that is our trademark. More information about Wells Fargo Advantage Funds is available free upon request. To obtain literature, please write, , or call: Wells Fargo Advantage Funds P.O. Box 8266 Boston, MA Website: wellsfargo.com/advantagefunds The views expressed are as of January 3, 2011, and are those of Wells Fargo Funds Management, LLC. The views are subject to change at any time in response to changing circumstances in the market and are not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally, or any Wells Fargo Advantage Fund. Bond fund values fluctuate in response to the financial condition of individual issuers, general market and economic conditions, and changes in interest rates. In general, when interest rates rise, bond fund values fall and investors may lose principal value. Certain investment strategies tend to increase the total risk of an investment (relative to the broader market). Consult a Fund s prospectus for additional information on these and other risks. The U.S. government guarantee applies to certain of the underlying securities and not to shares of the Wells Fargo Advantage Funds. Securities issued by the U.S. government are guaranteed as to the timely payment of principal and interest. Carefully consider a fund s investment objectives, risks, charges, and expenses before investing. For a current prospectus, containing this and other information, call or visit wellsfargo.com/advantagefunds. Read it carefully before investing. Wells Fargo Funds Management, LLC, a wholly owned subsidiary of Wells Fargo & Company, provides investment advisory and administrative services for Wells Fargo Advantage Funds. Other affiliates of Wells Fargo & Company provide subadvisory and other services for the funds. The funds are distributed by Wells Fargo Funds Distributor, LLC, Member FINRA/SIPC, an affiliate of Wells Fargo & Company Wells Fargo Funds Management, LLC. All rights reserved. FAWP