Despite numerous predictions that bond yields would soar (and therefore bond prices would fall), yields have actually fallen so far in 2014. After rising from record lows last year, the yield on 10-year US treasury bonds is currently around 2.5%, still far below its typical historical range. How long can bond yields stay so low? The answer is “possibly a very long time” based on the experiences of other countries.
The country that has the most experience with low bond yields is Japan. Following its real estate and stock market collapses a quarter century ago, interest rates started declining, with the yield on 10-year Japanese treasury bonds falling below 2% in the late 1990’s. It’s stayed below 2% almost constantly ever since, as weak economic growth and a low (even sometimes negative) inflation rate have given investors little reason to ditch the perceived safety of the country’s government bonds.
It’s unlikely that the US will experience such a lengthy period of such low yields. There are a few key factors working in favor of stronger economic growth for the US economy, such as more favorable demographic trends and an inflation rate that has mostly stayed in positive territory. In theory US policymakers should also be able to learn from Japan’s long stagnation to help avoid a similar fate.
Still, there’s no rule of economics that says that interest rates have to revert toward their average historical levels. The lesson from Japan’s experience should be that if economic growth remains weak and the inflation rate remains subdued (and there are plenty of economists who have this outlook), bond yields could remain low for a very long time.
The term “risk-free” is often used to describe treasury bonds issued by the US government. Yet in recent years Congress has repeatedly hesitated to raise the legal limit on the amount that the federal government is allowed to borrow, sparking panicked legislative deal-making to keep the government from defaulting on some of its debt. After one of these episodes, in 2011, Standard & Poor’s even lowered its credit rating for the US government. After this political buffoonery, should you still consider treasury bonds to be riskless? The answer is that from an investors’ perspective, treasury bonds were never risk-free.
This conclusion is actually unrelated to Congress, the debt ceiling, or the amount of debt the government has already incurred. With one of the world’s wealthiest populations, well-functioning government institutions (at least compared to many other countries), and its own currency (unlike the debt-troubled countries of the euro zone), it’s extremely unlikely that the US government would be forced to default on its debt. Political posturing notwithstanding, treasuries are still essentially risk-free when it comes to the risk of default.
Yet there are other risks for bond investors aside from a default. There’s inflation risk: since treasuries typically have fixed payments (the size of the periodic coupon payments is determined when the bond is first issued), an increase in the inflation rate will make these payments worth less. And there’s interest rate risk: if interest rates across the economy rise, the value of the bond will fall since other investments will offer higher returns.
Compared to many other types of investments these risks are fairly small. Last May and June, for example, as interest rates surged, US government bonds overall lost about 3% of their value (longer-term treasuries, which are more sensitive to changes in interest rates than shorter-term ones, lost about 10% of their value). Stocks, on the other hand, routinely gain or lose more than 3%, occasionally even in a single day. Still, a small amount of risk shouldn’t be confused with completely risk-free.