The Iran war, compounding federal deficits, shrinking foreign ownership of U.S. debt and the capital-intensive AI buildout have combined to spook the U.S. Treasury bond market. That’s pushed up the market yields now available on both fixed-rate and inflation-protected government bonds. For public pension fund officials, it’s a smart time to ask what’s the savviest and safest way to lock in some guaranteed long-term returns — and keep ahead of retirees’ dreaded inflation boogeyman.
These yield levels and payoff profiles now deserve a fresh look at where retirement-plan investors’ long-term risks are most likely to pose problems: inflation vs. bear-market recessions vs. stagflation. Each of those scenarios has portfolio implications. With stocks trading near record high price levels and a nagging sense that a bubble is forming around the AI revolution, government bonds may deserve a second look. But which kinds of bonds? Today’s Treasury markets present two quite different portfolio strategies.
Most public pension funds set their actuarial models for calculating contribution rates on the basis of expected returns from a diversified portfolio of stocks, bonds and other assets. Over the years, the average expected return on those portfolios has exceeded the assumed rate of inflation by about 4 percent. Actual average portfolio-wide returns have laudably beat those bogeys over the past 20 and 30 years, arguably because the global economy was resilient and U.S. inflation never broke out of control for too long. Typically, it’s been stocks, private equity, private credit and real estate that have produced the juice to beat inflation.
Rarely have bond yields come close enough to pension funds’ overall assumed return over inflation to warrant heavy investments there, which has led most plans to downplay their role in the portfolio except as a hedge against recessionary stock market slumps.
But in the long-bond market, we now see traditional U.S. T-bonds maturing in 30 years yielding over 5 percent. Aside from the short-lived 2023 post-covid inflation spike, that’s the highest long-bond yield we’ve seen since 2007 and the longest streak above 5 percent since then.
For those who expect the Federal Reserve to make good on its promised objective of lower inflation — supposedly a 2 percent rate — a T-bond market yield at today’s level starts to look pretty attractive to long-term institutional investors and even some middle-aged public employees saving for their retirement in workplace defined-contribution accounts.
For some, however, the risk of chronic future inflation should not be overlooked: Today’s long-term yields on Treasury Inflation-Protected Securities (TIPS) are close to 3 percent above the compounded CPI-indexed growth of principal they provide. That’s a locked-in inflation hedge well worth a second look.
Historical Yields on 30-Year Treasury Inflation-Protected Securities
As the chart shows, these TIPS yields are unprecedented in the past two decades. For those keen on market history, the highest TIPS yields were seen in 2000 during the dot-com bubble, when 30-year TIPS yielded 4.4 percent over CPI. That could happen again. So those who find today’s 3-percent-over-inflation TIPS yields attractive should keep in mind that market bubbles have a way of correlating with high TIPS yields, followed by skinnier payouts on bonds sold during recessions. They work the opposite of traditional fixed-coupon bonds as portfolio hedges. Neither instrument can hedge against both inflation and recessions.
The purpose here is not to make predictions or a market call, but rather to point out that we’ve now reached an historic level that warrants serious discussions by pension officials, and possibly some re-thinking of portfolio options by individual retirement savers and plan providers. Pension consultants should be taking the lead proactively with some solid research and client-specific recommendations for asset allocation and portfolio structure. Individuals will unfortunately have to figure this out for themselves, although sponsors of 457 and similar government defined-contribution retirement plans might want to review their “brokerage window” options to make sure that TIPS and long-term T-bonds can be purchased thereby.
Institutional Considerations
The various public pension associations will serve members well by adding this timely topic to their conferences and training programs. With these yields, TIPS may offer a viable, safer alternative to private credit and real estate. There’s an additional benefit: Empowered pension fund staffers could buy and trade in Treasury bonds and TIPS without paying fees to external managers. It’s important to note, however, that for the largest public pension funds, TIPS may have limited value because there is only so much supply of such long-term instruments relative to the megabillions held in those pensions’ bond portfolios.
The problem for defined-contribution retirement plans is that the traditional mutual fund industry presently offers few if any vehicles to facilitate long-bond and TIPS exposure for participants in the 40-70 age bracket. Numerous term-specific exchange-traded funds offering access to inflation-protected debt are available, but most are too short-term to materially benefit a retirement saver.
Managers of the popular “set-and-forget” target-date funds would do well to revisit their allocations in light of these new market developments. An inflation-guard target date fund option makes a lot of sense for defined-contribution menus, if only to shield their participants from a prolonged hyperinflation scenario. Such a fund could also include dividend-paying blue-chip stocks from industries with retail pricing power, and perhaps some high-quality real estate investments, so there would still be growth potential but with reduced cyclical risk.
If institutional demand for TIPS catches on, it won’t be long before the CME futures exchange, institutional swap shops and the nascent prediction markets start offering up supersized long-dated inflation-hedge contracts. Those would be “synthetic TIPS.” Where there’s an investment appetite and need, there will soon be a product line to meet it.
For individual investors, it’s important to note that TIPS accrue “imputed income” as they earn their semi-annual inflation increases in principal value, and that’s immediately taxable income in a brokerage account. For that reason, most advisors prefer to point their clients to tax-deferred IRA and generally tax-free Roth accounts for holding TIPS.
A Railroad Era Analogy
A brief history lesson is worthwhile here because the 1800s is an analogous prior economic period. The epic build-out of America’s railroad network and the industrial revolution in heavy industry like steelmaking required huge investments of capital, and that pushed stock speculation and bond yields to then-historic levels. Once the railroad network was largely complete, these new technologies paid off through unprecedented productivity, but the build-out bubble popped. That resulted in market bond yields subsiding — led in part by railroad barons’ defaults on bank loans and the collapse of many of the overbuilt and overleveraged railroad industry’s stocks and bonds.
The Panic of 1873 and price deflation during the ensuing Long Depression were directly attributable to the railroad and banking crash, with unemployment hitting 14 percent in 1876. (All this wreckage was considered part of the vaunted Gilded Age, mind you.) So there’s a lesson about laissez-faire capitalism to be learned from such boom-bust cycles that pertains to modern investment risks and strategies for pension funds and individual retirement savers.
What the 1800s cannot help us fathom is this century’s massive accumulation of sovereign debt worldwide and American politicians’ propensity to goose the economy with deficit spending financed with ballooning supplies of government bonds. It’s impossible to know how that ultimately plays out. The potential results could be higher and higher bond yields and commercial loan rates which eventually crush businesses owners and induce a recessionary market crash of some kind.
Alternatively, chronic escalating inflation could result from Washington politicians (including an accommodative Federal Reserve) taking the easy way out to cover the mounting debt with endless central bank purchases of Treasury bonds. A global run on the dollar and dollar bonds could have similar consequences. The latter scenarios are probably recipes for 1970s-style stagflation — and historians know how that impaired the stock market for almost six years and crushed public pension funds’ funding ratios for an entire decade.
In today’s world of data center buildouts, massive borrowing by corporations to finance those facilities, global government borrowing binges and the expected land rush for companies building factories to build robots later in this decade, it’s clear that supply and demand has now taken a turn in favor of the owners of capital. On its face, that’s good news for pension plans and retirement savers who supply capital. But it will take skill, strategy and some degree of good luck to pick entry points making good use of these opportunities — and to mitigate the downside risks. It’s impossible to know when this trend toward record-high long bond and TIPS yields will end or reverse course, but now is a good time to stop snoozing and hit the wake-up button.
Governing‘s opinion columns reflect the views of their authors and not necessarily those of Governing‘s editors or management. Nothing herein should be construed as specific investment advice.
