The 10-year U.S. Treasury note closed out 2012 yielding 1.76 percent. However, based on history it should have been 3.25 percent because the average Aaa corporate bond yield was 3.62 percent. Therefore, U.S. Treasury yields will increase in 2013 even if overall rates do not go up, because they are abnormally low. Here’s the reasoning.
If you look back over the last half of the 20th century you find that the yield on the 10-year U.S. Treasury note averaged 90.5 percent of the yield of Aaa corporate bonds. What this means is when the Aaa corporate bonds were yielding 5.0 percent the 10-year Treasury was at 4.5 percent; if Aaa corporates were at 10 percent, the 10-year Treasury was at 9 percent. In the early 1950s when the yield on Aaa corporate bonds was at 2.8 to 3.0 percent (even lower yields than today), the yield on 10-year U.S. Treasury notes was 2.5 to 2.7 percent.
Relative to Aaa corporate bond values, Treasury yields tracked very closely through both good times and bad. Until the Asian credit crisis in 1998, 10-year Treasury yields were never less than 79 percent of Aaa corporate yields, and even that ratio was quickly back over 80 percent by 1999.
The early 2000s were a different story. The millennium recession, although mild in the United States, caused credit problems in foreign markets, and that fear fueled an unjustified fear about U.S. corporate debt. Between the summers of 2002 and 2003, Aaa corporate bond yields averaged 6.1 percent, which should have meant a 10-year Treasury yield of 5.5 percent, based on history. Instead, however, Treasury notes paid 4.0 percent, or 66 percent of the Aaa bond yield, rather than 90 percent. Based on fear of foreign contagion and a possible double dip recession, investors did not so much as build in a risk premium for owning corporate bonds; instead, they created a safety rate discount for owning government debt. This caution proved unwarranted and those who had purchased Treasury notes instead of Aaa corporate bonds experienced relative losses as the correlation between the two steadily increased to 88 percent by 2007. To put a head on it, during this period, 10-year Treasury yields rose from 3.9 to 5.1 percent (and the market value of issued T-notes declined) and Aaa corporate bond yields barely moved from 5.7 to 5.8 percent (thus, market values barely stuttered).
The financial crisis of 2008 shook investor confidence and the credit markets to the core. Once again there was a flight to treasuries, but the safety discount became even more drastic with 10-year treasuries yielding less than 50 percent of Aaa corporate debt yields by the fall of 2008. This ratio steadily improved in 2009 and reached 73 percent by the spring of 2010, before slowly falling back again as worries increased about the strength of the recovery. However, the next stumble was strictly due to the summer 2011 folly in Washington with the debt ceiling.
In August of 2011, due to concerns that the United States might default on their bonds, the ratio again dipped below 50 percent and then got worse. By the time of the 2012 election the yield on 10-year treasuries was half of its long term ratio—45 percent. To put this into historical perspective, the 10-year U.S. Treasury note should have yielded 3.25 percent in November 2012—instead it was at 1.59 percent.
Simply put, based on the actual risk of default on corporate debt, the 10-year Treasury yield is far too low. Even if we approach this from the other side and say corporate yields are too high and should come down to the 2.7 percent range (only briefly seen 60 years ago), it would still mean 10-year Treasury notes should be yielding 2.5 percent today.
Different Standards for Today?
Because today is a different world than that of the last half of the 20th century, there is the possibility that the old metric of 90 percent may be obsolete because Aaa corporate debt is much riskier than U.S. debt—although the evidence doesn’t support this contention. However, even if the new ratio is 66 percent (which was the bottom ratio briefly a decade ago), this means 10-year treasuries should yield 2.4 percent today. If the new ratio is a much more likely 80 percent, it means 10-year Treasury notes should gradually increase to yield 2.9 percent even if overall interest rates do not increase.
Once again it appears the financial markets have severely overreacted to the possibility of default of investment grade corporate debt. However, rather than increasing the yield on the corporate debt, the market’s reaction has been to give a safety rate discount for U.S. debt, which is unwarranted. The end result is that even if rates on corporate bonds do not improve, the yields on Treasury debt will go up over the next couple of years, bringing a measure of relief to insurance carrier investment portfolios and allowing them to raise rates.
Neither Jack Marrion nor Advantage Compendium sell or endorse any financial product.
