The era of swelling Treasury auctions may be over for now, but investors are still about to absorb a historical deluge of long-term debt next year, with potentially painful implications for returns.
The math is simple: The Treasury is skewing its issuance more toward longer maturities, easing back on the bill sales it relied on in 2020 to pay for pandemic relief. At the same time, the Federal Reserve is likely to buy significantly less of the government’s debt on the secondary market in 2021, after hoovering up a massive amount this year to buoy the economy and keep markets functioning smoothly.
For JPMorgan Chase & Co., the biggest U.S. bank, the bottom line is that investors are going to have to soak up a lot more coupon-bearing Treasuries in 2021, to the tune of a net $1.84 trillion after taking into account the Fed’s buying. That’s an unprecedented annual amount, and it’s a staggering turnaround from this year, when a net $441 billion was sucked out of the market by JPMorgan’s calculation.
With such a big supply-demand shift ahead, yields might typically tend to climb, yet Wall Street sees only a modest march higher. That’s in part because there’s plenty of appetite internationally, given the world is awash in roughly $18 trillion of negative-yielding bonds, and the Fed’s Treasuries purchases, while reduced from 2020, will also still be a force. But with rates -- and coupon payments -- so low, even a small decline in Treasuries prices risks ending investors’ seven-year streak of positive total returns.
“The fact that the net Treasury duration hitting the market will almost double next year to a record is one key part of our calculus for yields,” said Jay Barry, a strategist at JPMorgan. “This combined with our expectation that economic growth will average an annualized 5% after the first quarter will push long-term yields higher,” though the increase will be restrained because of the Fed’s ultra-loose rate policy and investor demand for Treasuries.
Duration is how investors typically measure the impact on their portfolios from this sort of supply-demand swing. It’s a gauge of how much a bond’s price moves relative to changes in its yield -- the longer it is, the greater the price impact. So the net result is that portfolios will be more vulnerable to higher yields in 2021.
Fed as Key
The Fed is key to the market’s supply-demand dynamics next year. JPMorgan’s calculation assumes the Fed will purchase $960 billion of coupon-bearing Treasuries in 2021 via its bond-buying program, meaning it’ll maintain its pace of purchasing about $80 billion a month, currently spread across maturities.
Investors will still have to digest a record amount of government debt next year even if the Fed eventually tilts its buying more toward longer maturities. At its policy meeting this month, the Fed didn’t change the composition of its purchases, as some analysts had predicted.
This year, the Fed has bought about $2.3 trillion in Treasuries, nearly all in coupon debt. Those purchases have helped tamp down yields, and many analysts see rates struggling to regain their pre-pandemic levels in 2021, even taking into account roughly $900 billion in additional fiscal stimulus.
Some of the biggest dealers project that 10-year yields will end next year between 0.9% and 1.5%. That compares with the current level of 0.92%, and well short of the 1.9% mark at the start of this year.
Meanwhile, on the issuance side, most dealers see no change in 2021 to note and bond auction sizes, after the Treasury hoisted them this year to record levels. Banks expect the department to cut bill sales, after it issued over $2 trillion this year. Dealers also predict the Treasury will tap its $1.6 trillion cash balance as a source of funds. The department is also expected to keep increasing sales of inflation-linked debt, a category that happens to have relatively long duration.
The Treasury in May began to skew note and bond auction size increases more toward long-term debt, including to its rebooted 20-year bonds. It said in November that it planned to shift financing away from bills, which should result in a higher average maturity for its debt. That figure has fallen from the level of around 70 months where it had hovered since 2015.
The weighted average maturity should rebound to roughly 70 months in about a year, according to Wells Fargo Securities.
Of course, the prospects for economic activity, and yields, depend on the trajectory of the virus and the rollout of vaccines.
“A major portion of the yield rise we expect is due to the improving economy,” with the rest due to the weight of supply, said Praveen Korapaty, chief rates strategist at Goldman Sachs Group Inc. He forecasts the 10-year yield will end 2021 at 1.3%.
History also suggests Treasuries will remain in favor even as the stockpile has grown to over $20 trillion, from around $13 trillion just five years ago.
Commercial banks have been buying at a torrid pace, and many strategists predict that to continue, especially as the yield curve is expected to steepen.
There’s also likely to be demand from pension funds, which have been boosting their fixed-income allocation amid efforts to reduce portfolio risk. They may also shift money away from surging stocks to keep allocations from getting too imbalanced.
“As funding ratios get even better, it will make sense for the pension funds to take profits by selling equities and then re-balance by buying more fixed income as yields rise,” said Subadra Rajappa, head of U.S. rates strategy at Societe Generale. “Part of the reason we don’t expect yields to rise too much is because there should be good private demand, from pension funds as well as from foreign accounts.”
But even with solid demand, the supply overhang may bode for at least a modest rise in yields. And it won’t take much of an increase to cause pain -- with coupons so low, there’s little buffer against principal losses. That could spell a down year for managers tracking indexes -- for example, the Bloomberg Barclays U.S. Treasury index. The gauge has earned almost 8% this year, which would be the best annual return since 2011.
What Bloomberg Intelligence says
A vaccine-led economic recovery may cause a liftoff in Treasury yields that pushes the Bloomberg Barclays Treasury Index to its worst annual performance in over four decades. Index returns are rarely negative, but with yields so low even a modest selloff would push returns below zero.
-- Ira F Jersey and Angelo Manolatos
“Normally indexers get a nice tailwind from the coupon to help when prices are falling,” said Michael Cloherty, head of U.S. rates strategy at UBS Group AG, who predicts the 10-year yield will end next year at 1.5%. “But there will be no tailwind next year to help. So indexers don’t need as big a decline in prices to put returns into negative territory.”
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