Global Diversification Cushions a Brutal Year for U.S. Bonds
Treasury yields sit at multiyear highs while international bonds and junk credit blunt the damage
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Treasury yields sit near 2002 highs and long bond funds are deep in the red. International fixed income and junk bonds have softened the blow.
U.S. bonds take the hit
U.S. bonds are on track for one of their worst years since 2022, and investors who held only domestic debt have felt it most. The 10-year Treasury yield held at 5.22% on Wednesday, 1.19 percentage points above where it stood a year ago. On October 1 it breached a level last seen in April 2002 before easing.
Long-duration funds absorbed the worst of it. The iShares 20+ Year Treasury ETF (TLT) is down 10.8% year to date, and extended duration zero coupon funds have lost closer to 15%.
The front end has repriced too. The benchmark two-year yield sits at 4.80%, nearly a full point above the fed funds target range of 3.75% to 4.00%. The market has priced out rate cuts.
What drove the selloff
Three forces pushed yields up together. Oil has been volatile as the U.S.-Israel war with Iran obstructed crude exports from the Middle East, and Treasuries have traded in lockstep with crude. Supply added pressure, with the U.S. issuing $24.6 trillion of Treasurys through September, up more than 10% from a year earlier.
Stronger economic data and renewed inflation concerns completed the picture. Vanguard noted that the benchmark yield jumped 22 basis points in two days in late September, reaching 5.18%.
The move has been global. Yields have climbed in the U.K., France, Germany and Japan as well, so international bonds were not a clean hedge.
Where diversification helped
Investors with a slice of international fixed income lost less than those holding only U.S. paper. The cushion came from spreading exposure across different rate markets and currencies rather than from a rally abroad. German Bund yields hover near 3.5% and Dutch yields near 3.6%, both at levels not seen since 2011 in September.
French yields are near their highest since 2002, and Italian 10-year yields stand near 4.7%, up about 114 basis points from a year ago. Europe has its own fiscal problems, including a presidential election in France next April.
The case against leaning too far abroad is income. Schwab's Cooper Howard points to a yield gap of about 200 basis points favoring the U.S. aggregate index over the global aggregate. That carry is the reason some strategists still prefer domestic bonds going forward.
Junk bonds hold the line
High yield credit has been the quiet outperformer. The junk bond ETF JNK is roughly flat year to date, an 11-point gap over long Treasury funds. Higher coupons and short duration have offset the pressure from rising rates.
Credit buyers have not demanded more compensation for default risk, even as Treasuries sold off. That tells you the selloff is about rates and supply, not a deterioration in corporate balance sheets.
The risk is a change in that diagnosis. If oil stays elevated and yields keep climbing, refinancing costs for lower-rated issuers rise with them.
What to watch next
The 10-year yield now sits just under the October 1 peak of 5.243%. A close above that line opens the door to fresh multidecade highs. A retreat depends on Iran headlines. One strategist sees the yield falling to a range of 4.5% to 4.75% if the U.S. and Iran reach a deal to end the war.
Watch the benchmark yield against the 5.24% mark into Thursday's open. Oil is the signal to track.