Yield-starved markets flock to U.S. debt

The global fixed income market has faced considerable and increasing pressures since mid-2014. Global economic growth has begun to slow.* At the same time, commodity and energy sectors have experienced intense corrections (Chart 1). These downturns have been deeply rooted despite the absence of a global recession, and despite unprecedented monetary policies undertaken by major central banks.

Global bond markets have reacted to these macroeconomic downshifts, settling into configurations that we haven’t seen for quite some time; a substantial amount of global debt is trading at negative yields, and bond investors have turned to equities in search of income. At times, markets have felt somewhat distorted and unnatural.

Still, there is one noteworthy exception to the turmoil worldwide — the demand for U.S. debt has remained steady.

Spread levels tell the story

Proof of the endurance of U.S. debt can be seen in comparisons with some sovereign debt markets. For example, even though average yields declined on government debt globally (see Chart 2), spread levels between certain pairs of sovereign bonds remained within a persistent range. For instance, the spread on 10-year U.S. Treasurys versus 10-year German bunds has been consistent, averaging 157 basis points (with a standard deviation of just 11 basis points; see Chart 3).

By the same token, spreads between 10-year U.S. Treasurys and 10-year U.K. gilts have hovered around 30 basis points, while spreads between 10-year U.S. debt and 10-year Japanese debt have held at around 150 basis points for the same period.

In each case, policy surprises resulted in occasional spread widening, such as the Bank of England’s heavier-than-expected dose of quantitative easing, which elevated the spread level between U.S. Treasurys and U.K. gilts. Recent significant events such as the Brexit vote put pressure on spread levels as well (see the sharp uptick in Chart 4). We believe spreads could return to pre-Brexit levels again if the post-Brexit effects are less intense than expected. Otherwise, spreads may stabilize at the new level that has taken hold since Brexit.

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Recent history of U.S. inflation

Chart 1. Commodities hit turbulence: The S&P GSCI® Index

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Chart 1. Commodities hit turbulence: The S&P GSCI® Index

Data: Standard & Poor’s. Daily observations.

Chart shown is for comparison purpose only.

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Recent history of U.S. inflation

Chart 2. Yields on 10-year debt: A global decline

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Chart 2. Yields on 10-year debt: A global decline

Data: Barclays. Weekly observations.

Chart shown is for comparison purpose only.

View chart
Recent history of U.S. inflation

Chart 3. U.S. Treasurys vs. German sovereigns (spread analysis)

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Chart 3. U.S. Treasurys vs. German sovereigns (spread analysis)

Spreads settle into a range in the final months of 2014.

Data: Bloomberg. Weekly observations.

Chart shown is for comparison purpose only.

View chart
Recent history of U.S. inflation

Chart 4. U.S. Treasurys vs. U.K. sovereigns (spread analysis)

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Chart 4. U.S. Treasurys vs. U.K. sovereigns (spread analysis)

Except for a Brexit-driven spike, spreads become range-bound from late 2014 onward.

Data: Bloomberg. Weekly observations.

Chart shown is for comparison purpose only.

How did spreads between these pairs of sovereign bonds stay within such tight bands, particularly when facing such significant pressure from exogenous events? We find the answer in the consistent demand for U.S. assets — and not just Treasury assets, which are seeing reasonably steady bidding, but other types of debt as well.

Amid uncertainty, support for U.S. debt markets

We think one of the most pronounced aspects of today’s financial markets is the hunt for yield that is motivating global investors to reach outside of their home markets. This relentless focus on yield is showing itself to be contagious. We see it moving beyond the confines of small retail investors to large institutions like pension funds and insurance companies that are searching for yield in their portfolios.

Here’s how the resurgent demand for U.S. bonds has transpired in recent calendar quarters. For most types of U.S. debt, foreign purchases have been on the rise, according to monthly data released by the U.S. Treasury. (A close look at these developments is available in our earlier Insight, Adverse macro conditions cloud the Federal Reserve’s policy decisions.) Adverse macro conditions cloud the Federal Reserve’s policy decisions.) Adverse macro conditions cloud the Federal Reserve’s policy decisions.)

Significant inflows have made their way into types of U.S. debt that include:

  • Municipal bonds The U.S. municipal market has seen its 44th consecutive week of net inflows (as of Aug. 8), according to reports published by Lipper. The strength of the inflows can be credited to the persistence of offshore investors, despite the fact that municipal bonds, known for their tax advantages, are ordinarily not sought by ex-U.S. investors.
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  • Agency mortgage-backed securities This slice of the bond market has taken in $30 billion in the first six months of the year, driven primarily by Japanese investors, who accounted for more than 50% of all subscriptions. Taiwanese investors made purchases totaling $5 billion during the same period. Analysts expect to see an additional $80 billion make its way into U.S. markets during the second half of the year, with Japan generally the biggest buyer (data: Morgan Stanley).
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  • Real estate investments trusts (REITs) For the 12 months ended Aug. 4, flows into listed U.S. REITs reached $19 billion. Of the $14.6 billion that has reached the U.S. year-to-date, $12.7 billion has been from Japan.
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  • Dollar-denominated emerging markets debt As of Aug. 8, the most recent five weeks have witnessed significant inflows, reaching $4.4 billion, and accounting for most of the $5.1 billion that has arrived year-to-date. We expect to see reasonably healthy inflows continue through the second half of the year.
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The capital flows into U.S. markets noted above can be attributed in part to the slow-but-steady growth of the U.S. economy, which puts it in a favorable light relative to weaker economies around the globe. As we’ve noted in The U.S. is a role model in navigating the debt supercycle, the U.S. is also seen as leading much of the world when it comes to monetary policy effectiveness. Furthermore, as interest rates in a number of other countries continue to trend lower, the U.S. stands out as one of the few major economies offering positive rates. Indeed, it is one of the rare countries in which central bankers are deliberating rate hikes.

Looking ahead, we expect today’s conditions to remain in place: global growth creeping forward, if at a lackluster pace; global interest rates remaining low (possibly for a protracted period); and U.S. capital markets continuing to draw international investors.


*Analysis by Barclays shows global gross domestic product (GDP) growth advancing at a rate of 1.2% in 2013, 1.7% in 2014, 2.0% in 2015, 1.4% in 2016 (estimate), and 1.4% in 2017 (estimate).

The views expressed represent the Manager's assessment of the market environment as of September 2016 and should not be considered a recommendation to buy, hold, or sell any security, and should not be relied on as research or investment advice. Views are subject to change without notice and may not reflect the Manager's views.

Carefully consider the Funds' investment objectives, risk factors, charges, and expenses before investing. This and other information can be found in the Funds' prospectuses and their summary prospectuses, which may be obtained by visiting delawarefunds.com/literature or calling 800 362-7500. Investors should read the prospectuses and the summary prospectuses carefully before investing.

IMPORTANT RISK CONSIDERATIONS

Investing involves risk, including the possible loss of principal.

Past performance does not guarantee future results.

Fixed income securities can lose value, and investors can lose principal, as interest rates rise. They also may be affected by economic conditions that hinder an issuer's ability to make interest and principal payments on its debt. Fixed income securities may also be subject to prepayment risk, the risk that the principal of a fixed income security may be prepaid prior to maturity, potentially forcing reinvestment at a lower interest rate.

Narrowly focused investments may exhibit higher volatility than investments in multiple industry sectors. REIT investments are subject to many of the risks associated with direct real estate ownership, including changes in economic conditions, credit risk, and interest rate fluctuations. A REIT’s fund’s tax status as a regulated investment company could be jeopardized if it holds real estate directly, as a result of defaults, or receives rental income from real estate holdings. “Nondiversified” Funds may allocate more of their net assets to investments in single securities than “diversified” Funds. Resulting adverse effects may subject these Funds to greater risks and volatility.

Investing in emerging markets can be riskier than investing in established foreign markets due to increased volatility and lower trading volume.

International investments entail risks not ordinarily associated with US investments including fluctuation in currency values, differences in accounting principles, or economic or political instability in other nations.

Substantially all dividend income derived from tax-free funds is exempt from federal income tax. Some income may be subject to state or local taxes and/or the federal alternative minimum tax (AMT) that applies to certain investors. Capital gains, if any, are taxable.

The S&P GSCI, formerly Goldman Sachs Commodity Index, is a world production-weighted index composed of the principal physical commodities that are the subject of active, liquid futures markets.

The Bloomerg Barclays Global Treasury Bond Index measures the performance of government debt issued by 37 countries. The Index is a subset of the Barclays Global Aggregate Index, and only includes securities that are investment grade and have fixed-rate coupons.

Index performance returns do not reflect any management fees, transaction costs, or expenses. Indices are unmanaged and one cannot invest directly in an index.

Standard deviation, a measure of total risk, measures the historical volatility of returns.

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