PIMCO, a U.S. bond asset manager, warned on Thursday that U.S. Treasury term premiums, a gauge of the compensation investors require for holding long-term bonds, may surge once more amid persistent inflation and mounting fiscal deficits.
Term premiums, which have the potential to negatively impact assets like stocks as they increase, have remained subdued for approximately a decade due to low interest rates stemming from the aftermath of the 2007-2009 global financial crisis and the subsequent COVID-19 pandemic. Even before these events, premiums had been steadily declining since the 1980s.
Marc Seidner, PIMCO’s chief investment officer of nontraditional strategies, and Pramol Dhawan, head of emerging markets portfolio management, expressed concerns that the long-term downtrend in term premiums could be poised for a reversal. They highlighted a stronger-than-expected inflation reading in January and projections indicating rising fiscal deficits and the consequent need for increased debt issuance as factors likely to drive up term premiums in a sustained manner.
The duo emphasized that borrowing costs and ongoing deficits are on the rise, leading to a clear expectation of continued increases in interest expenses.
The term premium associated with benchmark 10-year Treasury yields currently stands at minus 0.3%, as per a gauge from the New York Fed. This metric turned positive last year amid concerns surrounding escalating fiscal deficits and an uptick in government bond issuance, leading to an increase in long-term Treasury yields. However, it subsequently reverted to negative territory amid expectations of interest rate cuts by the Federal Reserve.
According to Seidner and Dhawan of PIMCO, a resurgence of term premiums to levels around 2% witnessed in the late 1990s and early 2000s could have significant repercussions not only on bond prices but also on the valuation of other assets such as equities and real estate, which are influenced by discounted future cash flows.
They further noted that the Treasury yield curve, which currently exhibits inversion in certain segments due to short-term bonds yielding more than longer-dated ones, could undergo correction driven by rising term premiums alongside an anticipated shift by the Federal Reserve towards lower interest rates.
PIMCO’s portfolio strategy reflects a “curve-steepening bias,” with a preference for maturities ranging from five to 10 years globally, while maintaining an underweight position for bonds with approximately 30-year maturities. The analysts pointed out the possibility of a curve “kink” occurring post the first Fed rate cut, where shorter-term yields decline, intermediate rates remain relatively stable, and longer-term yields rise as term premiums make a resurgence.