Don't let them scare you out of bonds: The fixed income value proposition must look beyond supply | Fixed income market commentary 2Q 2024
Oakmark is the mutual fund family launched in 1991 by Harris Associates, the Chicago deep-value firm founded in 1976 (about $105bn AUM). Bill Nygren runs the flagship Oakmark Fund and David Herro the Oakmark International Fund, buying businesses at large discounts to intrinsic value and holding them like owners — publishing quarterly fund commentaries, market commentaries and insight articles.
In plain words
Many investors worry that too much government debt will hurt bond returns. This report argues that's not the key factor. What really matters is the real yield (bond return after inflation). Historically, high bond supply hasn't led to low returns. Today, about $6 trillion sits in money markets (short-term, low-risk funds). When the Fed cuts rates, that money is likely to flow into longer-term bonds — far more than the new supply. For regular investors, now might be a good time to consider higher-quality bonds with longer maturities. Don't let supply fears keep you out.
The Oakmark report refutes the pessimistic view that "excess bond supply will lead to low returns," arguing that this is an oversimplification of fixed income's value proposition. The core argument of the report is that fundamental factors (such as rising real yields) drive demand for high-quality f
Theme and Background
This chapter refutes a popular pessimistic view in the market, namely that "future bond supply gluts will lead to low or even zero returns." This view likens bond investing to Sisyphus in Greek mythology, arguing that investors will see total returns driven to zero as governments issue massive amounts of treasury bonds to cover deficits, the market fails to absorb them, and yields are forced higher. The report argues that this assertion is a severe oversimplification of fixed income's value proposition.
Core Thesis
The author's core investment argument is: Fundamental factors (especially real yields) are the dominant drivers of bond returns, not supply alone. Supply has some impact on short-term returns but cannot explain medium- to long-term returns. The author presents a counterintuitive judgment: when real yields rise, demand for high-quality fixed income instruments actually increases (demand is elastic), thereby absorbing supply pressure. Additionally, the current unique interest rate environment (the longest yield curve inversion in history) has trapped approximately $6 trillion in money markets. Once the Federal Reserve begins cutting rates, these funds will flow back into the bond market on a massive scale, far exceeding new supply.
Key Arguments and Data
1. Very Low Historical Correlation: The report compares data on 10-year U.S. Treasury issuance and returns from 2006 to 2023, finding no stable negative correlation between the two. If the "supply leads to low returns" argument held, years with high issuance should consistently show negative or low returns, but historical data does not support this.
2. Principle of Demand Elasticity: When real yields (returns adjusted for inflation) rise, investors shift from assets like money markets and equities into bonds, thereby creating demand. The report considers this "fairly intuitive" economic behavior.
3. Uniqueness of the Current Environment: The post-COVID inflation shock, rapid Fed rate hikes, and massive fiscal stimulus have combined to create the "longest yield curve inversion in history." This environment has spawned approximately $6 trillion in money market assets (enjoying over 5% short-term risk-free returns) and an estimated over $1 trillion in high-quality fixed income funds locked in short-duration positions.
A scatter plot of 10-year U.S. Treasury issuance and returns from 2006 to 2023 shows no significant negative correlation. Issuance fluctuates between $200 billion and $1.5 trillion, while returns are dispersed across a range of -15% to +20%, indicating that high supply is not the sole determinant of returns.
| Metric | Data |
|---|---|
| Money Market Asset Size | Approximately $6 trillion |
| Estimated Short-Duration Fixed Income Funds | Over $1 trillion |
| Current Short-Term Treasury Yield | Over 5% |
| Historical Comparison Period | 2006-2023 |
Companies/Assets Involved
- U.S. Treasuries: The core subject of discussion. The report argues that despite increased supply, fundamentally driven demand (especially when real yields rise) is sufficient to absorb it.
- Money Markets: Viewed as a potential source of funds flowing back into the bond market. The current ~$6 trillion here will shift to longer-duration bonds once rate cuts begin.
- Short-term Treasuries: Currently attracting significant funds due to the yield curve inversion, but their appeal will diminish after rate cuts.
Investment Implications
- Do Not Avoid Bonds Due to Supply Fears: Investors should focus on real and nominal yield levels rather than worrying solely about supply. The current environment of high real yields and low breakeven inflation rates suggests that forward returns over the next 3-5 years may be above average.
- Focus on Fund Inflow Opportunities: As the Fed begins its rate-cutting cycle, the massive funds in money markets and short-duration bonds (~$6 trillion + $1 trillion) will likely flow into the longer-duration bond market. This incremental capital will far exceed new Treasury supply and could act as a catalyst for rising bond prices.
- Allocation Direction: Investors are advised to consider increasing allocations to long-duration, high-quality fixed income assets to capture capital gains and higher forward returns during the rate-cutting cycle.