What a carry-on: starting yields as a valuation tool for sovereign bonds

Key takeaways: 

• We find initial valuations, or starting yields, are indeed strongly correlated with future returns.
• Peak correlation occurs where the maturity of the US Treasury index is closest to the investment horizon, i.e., 2 yrs for the 1 to 3 year Treasury index, 7 to 10 yrs for the 7 to 10 year Treasury index, and at 20 years for the 20 years + index.
• Wide yield ranges between 2000 and 2026 mean price and duration effects on returns vary but mean reversion in yields causes price effects to average out in the longer term, leaving starting yields and roll-down as the key drivers of returns.

Points of differentiation: 

• By using FTSE Russell constant maturity indexes, we are able to prevent pull to par effects distorting the correlations for single bonds.
• We also assess the relationship between yields and returns in different yield regimes, and the impact of changes in yields, versus initial yield levels, on returns.
• Again, we find starting yields are the key variable, and that returns can be higher, even in rising yield regimes, due to carry and roll-down effects exceeding price effects.

What does our research mean for investors?  

• We recognise auto-correlation in returns time series is evident, but this does not mean the impact of starting yields, or carry, in driving returns is not still significant.
• There are good economic reasons to expect autocorrelation in both govt bond yields and returns anyway, from central bank forward guidance on rates, to protracted business cycles, to relatively stable inflation expectations, and to predictable carry and roll-down on the yield curve.