With U.S. markets sliding into bear territory, yields on U.S. Treasuries have tumbled to historic lows as investors have sought their safety given the economic uncertainties around the spread of the coronavirus. The yield on the benchmark 10-year U.S. Treasury fell as low as 0.3% following the Feds emergency rate cut last week and in anticipation of another cut next week. Given the importance of U.S Treasuries in the global financial system, yields at these levels are likely to present unforeseen dynamics across markets and through the financial system.

To get a better understanding of how that might play out, I spoke with Collin Martin, Managing Director and fixed income strategist for the Schwab Center for Financial Research. Schwab manages some $3.7 trillion in assets, and offers a variety of mutual funds, ETFs and investment products in fixed income.

Silver: Why should investors be concerned about declining yields for U.S. Treasuries, especially with the 10-year below 1%?

Martin: So I think there's two ways to look at it. The first concern is what that level of yield tells us—that economic growth is likely to slow, inflation is likely to be low. And it's a pretty gloomy forecast. I think what's more troublesome is what it means for actual investors. The concern is, we've been in this low interest rate environment for so long and now we're back to this historically all-time-low interest rate environment. And I think it's now easy for a lot of investors to say, well, why should I invest in any of these bonds or high quality fixed income investments because they're just not offering me much fixed income right now? We think there's always a place for bonds, but I think with the low level of yields, it might make a lot of investors a little bit wary of investing in anything right now.

Silver: Right. But even though they're saying no—no return or no yield—investors have been piling into it as a flight to safety as the stock market has corrected.

Martin: This is a big challenge for individual investors and you know, it's frankly something that I've been concerned about for the past few months. We went through this zero interest rate or near zero interest rate policy by the Fed from 2008 to 2015 and we finally got to this level where we saw something that seemed somewhat attractive. Now, just to a year or so later, we're back close to zero. And it's this huge challenge for investors. If you invested in years past and you're holding bonds, you can still continue to earn those yields. But for anyone who's been on the sidelines and been waiting for a better entry point, it's just extremely difficult for individual investors right now.

Courtesy YCharts
Courtesy YCharts.

Silver: So let's talk about some of the knock on effects of the 10-year other long term U.S. treasuries with such low yields. Obviously it's telling us about slow growth, but we also know people have been hiding out in it as a safety asset. But how does that play into the U.S. economy's slowdown?

Martin: So heading into 2020, we thought the economy was doing okay. We didn't think it was going to suddenly go gangbusters, but we thought that the risk of a recession had been pushed back a little bit. That was kind of all the talk in early to mid 2019. But as we entered this year, the economy appeared to be on solid footing. Now, we have the dual threat of the coronavirus and the shocks of the oil markets from Russia and Saudi Arabia. That's potentially going to pull our economy significantly lower and slower. And, and we think that the risk of a recession is relatively high now.

Silver: Right? On the flip side, lower treasuries maybe good for reducing mortgage debt and other products based on the 10-year. How might this help consumers and will it have any impact if the economy slows?

Martin: It can help. I don't think it's a cure for this, but it certainly helps. So if you're a potential first time home buyer or someone looking to refinance, this certainly provides an opportunity at all-time-low levels for mortgages. So that's great in that it can reduce mortgage interest, that interest expense, which can actually take up a big chunk of an individual's budget. On the corporate side, I think there's a few ways to look at it. When the Fed cut rates, there was a lot of concern about what good is this going to do? A Fed rate cut isn't putting people back in a factory. It's not getting airplanes back in the air. But there is a silver lining that there's a lot of companies and firms out there that have credit lines, credit facilities or any or other short term borrowings that are tied to short term interest rates.

So that cut did help. It lowered their interest expense if it's a floating interest rate, probably 50 basis points. And if they cut again, that could be another 50 basis points lower in their interest expense. That's the good news. But the bad news is it kind of sent the signal that things are actually pretty bad, the outlook's not very good right now. So for people looking to get a loan or more importantly, I think corporations looking to get a loan, even though rates have come down, I think lenders are probably a little concerned with lending money to some risky borrowers right now.

Courtesy YCharts
Courtesy YCharts.

Silver: That actually is not a bad thing given what happened in 2008.

Martin: Yes, and that's been a risk for a while now. A lot of corporations have kind of been surviving just because of the low interest rate environment and now if that gets pulled out from under them and they're not able to refi accordingly, that poses a significant risk.

Silver: What about sovereign governments who are the biggest holders of U.S. Treasuries besides the U.S. government itself? I'm talking about, you know, Japan or even China, they're big holders of U.S. Treasuries. What does it mean with yields at these levels for them?

Martin: Their yields are coming down. Unfortunately, the interest they're earning, if they're pumping new money into our treasuries, will likely decline, but it's still higher than what they're getting from other countries. If you look at the Japanese government bond market, the German government bond market, we still offer a significant yield advantage relative to them. So for most international economies or treasury investors, even though our yields are at 1% or below, and don't look very attractive on a relative basis, they still look attractive because you're still getting that yield advantage.

Silver: Do you expect a slow down in purchases of U.S. Treasuries by sovereigns?

Martin: No, we don't expect to slow down. I mean, if anything, this drop in yield shows that the demand is still strong. I mean there's no shortage of demand for U.S. Treasuries, especially in an environment like this. And given that even though our yields have come down, given that we still do offer an advantage relative to these other high quality bonds like a Japanese government bond or German government bond, unfortunately it means that there could be room for our yields to go even lower. The fact that we still offer that advantage means that there can continue to be demand as long as you're earning that positive spread.

Silver: What about credit spreads for U.S. corporations? What concerns do you have as yields go lower or hang out below 1%, about their spreads and credit/debt risks?

Martin: We had been pretty concerned with U.S. corporations and corporate risk, for awhile now, really since the middle of last year. And we'd cautioned our investors about going too much into the corporate bond markets. And where we are now, we've seen this significant shakeout of the market, especially high yield bonds where spreads have surged. High yield spreads are the relative yield they offer above and beyond. Treasury yields are back well above their long term average, almost two percentage points above their long term average. So they certainly look more attractive than they did. But we're stopping short of suddenly suggesting or recommending our investors move in because we think it can get worse. And we're a little bit cautious about trying to catch a falling knife.

Silver: There was also a ton of money on the sidelines in 2019, despite the fact that the S&P was up 30%, a ton of money flew into corporate bonds, U.S. bonds, and money market funds. Do you have the sense that there's still a lot of institutional money out there that's looking to go to work right now? Or is it just going to camp out there until this crisis passes?

Martin: I think there's a good chance that it camps out for a little bit. I mean, there's so much uncertainty right now that I imagine a lot of investors are probably going to look to stay on the sidelines and just see how it shakes out a little bit before they suddenly make a big bet.

Silver: What about the possibility of negative interest rates here in the U.S.? What could go wrong?

Martin: Our stance there is we don't think the Fed will likely go negative. They've been pretty explicit that they're happy with the tools they currently have in their toolkit. So for now, we don't think they'll set their policy rate below zero, but we do then give the caveat, that doesn't mean that other treasury yields can't go below zero. It doesn't mean markets can't bid up the prices of two or five or seven year treasuries and push those yields even lower. So it's not necessarily our forecast, but it's a possibility, unfortunately, if the market or the economic outlook continues to deteriorate.

Silver: What's the worst that can happen if we do go negative or not?

Martin: Our biggest concern, especially on the fixed income side, is where individual investors put that money that would have been earmarked for bonds. Now, just because Treasury yields go negative, it doesn't mean they can't find a positive yield and say an investment grade corporate bond or a muni or a mortgage backed security. But given if Treasury yields were to go negative or just slightly negative, our concern is that we'd be in an environment where investors would be reaching for yield too much. And that's something we generally tend to caution and push back against. We don't want investors taking on too much risk and that would be a likely option for a lot of investors versus, you know, locking in a guaranteed loss if you're buying a Treasury with a negative yield.

Silver: Are you worried that they'll go into stocks or are you worried they'll go into other obscure securities that have attractive yields or, even some sectors that are popping pretty big dividends right now?

Martin: I'd say all of the above. Whether it's stocks, whether it's high yields, whether it's bank loans, you know, not that there's anything wrong with those in a well diversified portfolio, but our concern would be that maybe these portfolios would be significantly less diversified than they would have been otherwise if we saw positive rates. You know, if that bond allocation that you're supposed to have of high quality bonds, you know, maybe a big portion of Treasuries, if that suddenly shifts out to high yield bonds and stocks instead because you want higher yields, that's a concern.

One thing that we're kind of cautioning investors against now, you mentioned people being on the sidelines for those on the sidelines right now, kind of hoping, waiting or maybe hoping for a better entry point to the bond market. If the economic outlook— I would say not even deteriorates, just kind of stays the way it is right now—we're probably going to see the Fed cut again and it's probably going to go back to zero. So if you're waiting on the sidelines, there's a good possibility that the short term investments you're used to, whether it's a money market fund or a Treasury bill or a short term CD, there's a good chance those are going to get back close to zero also. So by at least owning something with a positive yield, even if it's 50, 60, 70 basis points rate right now, we'd rather lock that in at least for some of your money. rather than just riding that wave back to zero.

Bank Stocks YTD
Bank Stocks YTD.

Silver: Yields this low, pretty rough for banks, right. On the net interest margin.

Martin: That really just goes back to the concern about the economy and corporations. Not that we think any large financial institutions are going to have major problems. Banks are really the lifeblood of the economy and if net interest margins come down and we see this super flat yield curve at very, very low levels that can have a really negative impact on banks. So that's one more reason why we're still cautious right now and why we're not really confident going into many risk assets on the fixed income side because we do think things can get a little bit worse.