Economic/ Investment Commentary by Mark Del Pezzo, CFA firstname.lastname@example.org
Rough Seas Ahead April 2015
Kind of like the last few hurricane seasons in the great state of Florida, the bond market has not had a bear market in quite a spell. Like our dreaded season, we hear the forecast of 8 -10 storms and have been lulled to sleep by the good fortune over the past several years. In my opinion, this describes most investment funds in the bond market on a global basis. This is especially true for investors in ETF’s and Mutual Funds that do not have a stated maturity! It has been a long time since rates have trended higher, so let’s start the discussion with a graph showing what happened in 1993 to 1995 and the impact on Treasury prices. For this illustration, I will use a BB graph of an actual 20 year maturity US Treasury security price and yield.
BB graph of 20 year U.S. Treasury in time frame 1993-1995
BB graph of the Federal Funds rate in 1993 - 1995
As the treasury graph shows , the move in price was from the high point in October 1993 of 115 to the low point in November of 1994 of 90 – a negative decline in the price of the security of -22%! This move down in price coincided with a rise in yields on the security of 2.25% or 225 basis points. Over this time frame, the Fed Funds rate graph shows that the FF rate was raised from around 3% to 5.5% or 250 basis points. This is one of the few times over the past 30 years that the Federal Reserve was in a rate raising mode. So what does this mean to todays fixed income investors?
Quite simply, it means that great price risk is embedded in fixed income instruments today! As my former boss Ben Pace who served as the CIO of Deustche Bank in the U.S. jokingly says - one of the first things you should learn when managing bonds is don’t lose money! Well, many investors and investment professionals have never seen a bear market in bonds and I am not sure how they and more importantly clients will react when and notice I say when this happens again… This is particularly true in today’s environment due to the fact that coupon rates are so low that the duration on fixed income securities is longer in the markets today. In layman’s terms – when you are earning a whopping 1-2% coupon rate, it takes a long time to make up for a 20% plus shortfall!
Many investors are invested in bond mutual funds and ETF’s (exchange traded funds) and may believe that professional managers in the case of mutual funds and the liquidity in the case of ETF’s will cushion the blow of a rise in rates on their bond investments. As one can see by the following graph, not so fast my friend -
BB graph Pioneer open ended bond fund in 1993-95
As one can see the price decline again was pretty serious at 7% - kind of luck getting smacked by a rogue wave when sailing a small vessel! During this time frame as I recall from managing funds through this period, it took several years to make up for the short fall and earn a real return on the bond component in most portfolios. At this juncture, with yields at 50 year lows, it will take even more coupon clipping to get back to even and make any real return if we have a bear market! To keep with the sailing analogies this is like bailing out water in a boat with a coffee cup…
Regarding ETF investors, in my opinion this group of investors is in for the biggest surprise because although ETF’s trade on the market like common stocks and appear very liquid, the underlying securities may or may not be that liquid. A quick example would be the typical bond ETF holding a mix of corporate, mortgage backed and treasury bonds. The U.S. treasury market is very liquid and deep and will probably not present a problem as far as liquidity goes, but the corporate and mortgage backed markets are a different story altogether. For example, the large investment banks used to make good markets in many corporate issues but primarily due to regulatory pressure combined with much thinner profit margins on trading bonds, the big broker dealers are only making markets with good size in the largest high quality issues. What will happen if rates rise faster than investors think and the urge to protect investments takes hold and investors decide to cash out of ETF positions? I think this will lead to even worse price depreciation than could be forecast purely from a duration perspective!
BB graph of LQD ETF during taper tantrum of 2013 when rates rose by 140 basis points on the 10 year
Wow - as one can see the LQD ETF containing high grade securities declined by over 10 points or around 10% in just this early preview of what may happen when rates finally rise! This is a bit more than the general duration of the fund would tell us it was supposed to decline! Could this be the sign of a liquidity issue?? If this were a horror movie the preview was pretty scary, so stay tuned.
This is even more concerning due to the fact that most investors think of the bond component as the “ballast” in their asset allocation program. Bonds have proven to be very good shock absorbers and good at cushioning the blow when the equity markets are volatile and decline. My point is most investors do not expect the bond component to decline very much and think the bond component will dampen risk over time. All that said, we do not anticipate a major bear market for the next 12- 18 months, but we do believe rates will slowly trend higher over the next few years. The Federal Reserve has kept the FF and rates at historically low levels since the financial crisis in 2008 by cutting the short term borrowing rate or FF rate and “sitting” on the longer end with QE. At some point, the Fed would like to get rates back to somewhat normal levels but how fast will be dependent on the data. Many forecasters thought rates would be higher by now and the Fed is being too loose in policy for too long. One of the reasons they have been so firm in keeping rates so low is that demand is still very squishy and supply particularly on the labor side is still ample. The best way I have heard someone describe Fed policy over the past few years is a quote from Paul Mcgulley formerly the Chief Economist at PIMCO – the Fed is offering free beer at a college fraternity party at 6 AM on a Sunday morning. The demand for the cheap money is still low as is the demand for free malted beverages early Sunday morning! The Feds internal goal is to get the FF rate back to around 3-4% somewhere around 2017 – 18, but this is based on Fed economic forecasts which are almost as reliable as Florida meteorologists in storm season. All kidding aside, if they are half correct rates drift up 1- 200 basis points from here.
How can investors protect themselves in the coming storm? To start with just being cognizant of the potential risks is very important. First, investors should own ETF’s and bond mutual funds that pay strict attention to duration and extension risks and have been successful at navigating rough waters before. This is very difficult to find in today’s environment due to the fact that we have been in a bond bull market since the mid 1980’s. The best way in my opinion to protect purchasing power and capital is via a good bond ladder and / or utilizing professional management that is intent on building good well-structured ladders of bonds that will reprice and take advantage of rising rates and most important give the investors back their funds at the stated maturity date!
Bottom line, it is time to be very attentive to how the FI managers in your portfolio are structuring their ladders and what types of securities they hold. For example, managers can hold significant weightings in mortgage securities which have embedded extension risks. Briefly, this is the risk that the potential price risk of the bond will be greater than the stated duration indicates, as rates rise. Just another item that requires close monitoring and attention.
In closing, FI still is a very important part of the asset allocation strategy for investors ,particularly as a shock absorber and diversifier of risk, but it must utilized in a smart way or it may not provide the ballast that investors have come to expect!
Mark Del Pezzo, CFA