Today’s Reality
We live in an era of heightened economic uncertainty, unprecedented political instability and diminished personal safety. It should come as no surprise to us, therefore, that volatility in all financial markets remains high.
In the midst of this uncertainty however, one of the few things in the world today that is predictable, is the fact that interest rates in the US are going up and will continue to go up.
And that of course creates a problem for traditional Fixed Income investors. While buy and hold investors may well be happy with the coupons they are earning, and the credit risk of the bond they are holding, it is a fact that even they are subject to the vagaries of bond prices, should there be a need to either sell the bonds or value the portfolio at current market prices.
The Impact of Rising Interest Rates
It is important even for the most uninitiated amongst us understand one thing as Bond investors (and I do apologise to the savvy investors reading this piece for the small lesson in Bond mechanics here) – there is an inverse relationship between interest rates and bond prices.
To put it simply, if you bought a 10-year maturity bond that paid 5% p.a. when it was issued in 2013, and if interest rates are higher today, it makes sense that you should get paid more than 5% p.a. for a 10-year maturity bond from the same issuer if you were to buy it today as a new bond.
But if you are holding that bond issued in 2013 in your portfolio, you will be earning lower coupon than the investors who buy bonds issued today. This lower coupon will be reflected in the current price of the bond.
Therefore, notwithstanding how good the issuer of the bond is doing, and how good that credit risk continues to be, if you were to sell your portfolio today or borrow against it, the valuation would be lower than that in 2013.
If the issuer does not default on the bond redemption at maturity, you will indeed get your capital back and hopefully all the coupons until then, but between now and that maturity date, the value of your portfolio will continue to be less than what you would expect if rates had not moved.
It is good to be aware of that as we set out to examine what has been happening with interest rates in the past few years, and expectations for the future. And of course, this has immense relevance for the decisions that we take as investors going forward.
What has happened with Interest Rates in the past Ten Years?
Anyone who has an outstanding mortgage or money in a bank will tell you there is only one answer to that question – Rates have gone lower and lower, and stayed low, as the world has gone through the worst Global Financial Crisis (GFC) since the Great Depression of 1929.
Exactly ten years ago, as a result of years of profligacy and greed among borrowers and lenders alike, the Subprime Mortgage Crisis blew up in the United States. This ballooned into an international banking crisis in 2008, and that quickly spiralled out of control, until we were all left with something that tasted far worse than egg on our faces.
Anyone who has read (preferably) or seen Michael Lewis’ “The Big Short” needs no further explanation, and whoever has not seen or read it, should do so right after you finish reading this piece.
To tackle this spiralling crisis, there was only one tried and tested formula that Central banks the world over, found was effective - Lower interest rates.
“Emergency Measures” to provide liquidity to banks, became an ongoing economic recovery formula, as the Fed’s zero interest rate policy (ZIRP) and quantitative easing programmes were copied more often by other Central banks around the world, than Chinese companies “acquiring” latest technology.
And for the next eight years or so they used it until rates could go no lower.
And then rates went lower.
For the first time ever, multiple countries around the world had negative interest rates. You had to pay the bank to make them hold your money for you without giving you anything in return.
The Central Banks of Eurozone, Denmark, Sweden and Switzerland followed Japan into negative rate territory in 2016.
And the Bond Market flourished.
When you could not earn anything from keeping money in banks, you bought Bonds. As rates fell, and bond prices went up, your portfolio looked in healthy positive territory, and you bought more bonds.
It became a self-perpetuating reality.
The 10-Year US Treasury Yield had gone from 4.64% in January 2007 to 1.32% in July 2016, which was the low point of the yield.
You would not however be reading this, if something important had not changed.
Nine years of throwing cash at the problem, and the benevolent effect of ‘Father Time’ had finally worked its magic on the US economy. And for the second time in nine years, the Fed raised interest rates in 2016.
The Fed raised rates 0.25% in December 2015 as well. But that was perhaps a tad too early. Given economic data coming out of the US in the past several months, the recovery appears to be well and truly under way now. This is why Janet Yellen’s recent quarter-point hike is a whole different ball game.
To reflect this fact, at the start of 2017, the 10-Year US Treasury was back up to 2.43%, a substantial 84% increase in the yield in just six months.
So what does the future hold for Interest Rates?
To answer that question, we have to look at what has been happening to the world economy recently, specially the US. Let us look at a few graphs, for it is correctly said that a picture is worth a thousand words.
Source: Bureau of Economic Analysis
Percentage Change in Real GDP by State, 2016:Q1-2016, Seasonally adjusted at Annual Rates
Source: Bureau of Economic Analysis
Not only did Real GDP increase in the US by 3.5% p.a. in comparison to the 1.4% p.a. in the previous quarter, but it also increased in each of the 41 of the 52 United States.
Source: U.S Department of Labor
Source: U.S Department of Labor
US initial jobless claims, a bell-weather predictor of economic health if there was any, shows a sharp decline, while the Unemployment Rate remains at a nine-year low that it achieved in the previous month.
Source: U.S Department of Labor
The Core Inflation Rate showed a 2.1% increase, and threatens to climb back to 2008 and 2009 levels of 2.5% p.a. in the none too distant future.
Source: University of Michigan
Finally, the United States Consumer Sentiment for the United States rose to 98.2 in December, the highest reading since January 2004. No mean feat for an economy coming out of the worst financial crisis in over 80-years.
These are all factors, that not by themselves, but taken as a whole, gives ample indications that the US economy is on a strong footing.
Not surprisingly then, the Fed has spoken of multiple rate increases over the next year or so to bring normalization to the economy.
Source: Bloomberg
A look at the 40-year chart of the Fed Funds Rate above is the final piece of the puzzle in understanding how unsustainable the current level of rates is.
It is clear, given all of the above, that there is only one way interest rates are headed in this cycle – UP. While rates may not go back to historically “normal” long term levels of 5% p.a. anytime soon, any moves up from here will be fast and potentially brutal.
In the meantime, what has been happening in the Bond Markets?
Source: Bloomberg
The US Treasury was around 3.82% at the time of the Lehman bankruptcy. It saw its low point in July 2016 @1.32% p.a. and is now up to 2.49% p.a. Given that this is the benchmark that is used across Bond markets, it’s a reflection of the sell-off in bonds that has happened in a small way, but more crucially, a prelude to what can happen when rates go up further. And that, clearly, is only a matter of time.
But that’s not the whole story when it comes to Corporate Bonds, as the graphic below clearly shows.
Source: S&P Dow Jones Index
A glance at the S&P Dow Jones Equal Weight Corporate Bond Index, which was launched a bit over 10-years ago, provides interesting perspective on how the Corporate Bond market has behaved in the last 3 years, and helps us compare and contrast the moves with the 10-Year Treasury, the “risk free” version.
A year ago, when the Corporate Bond Index yielded 3.41%, the UST yielded 2.16%, i.e. the risk premium over the UST was 1.25% p.a.
In July 2016, at the low point for yields, the Bond Index yielded 2.58%, while the UST paid 1.32%. Hence the risk premium was now 1.26%.
However, now, when rates look like they are finally on their way up for the medium term on the back of a strong US recovery, the risk premium is down to 0.76%. What is clear is that corporate bond prices have been much stickier than the Treasury in response to interest rate moves and expectations.
Again, this makes eminent sense, because not only is the Corporate Bond Index showing that yields are beginning to go up, but the lower risk premium is also a reflection of the fact that with economic recovery in the US well and truly underway, the credit risk of the names that make up this Investment Grade Index is relatively lower, with the assumption that they do better in a more benign economic environment.
With rates virtually at zero, and no clear view on when a rates rally would happen, holding Bonds has been a prudent strategy as long as one is comfortable with the underlying credit risk. It follows therefore, that merely yield expectations are not going to linearly impact the prices of these bonds because the biggest risk in the minds of private and institutional investors at this stage, is re-investment risk. I.e. if you sell the bonds, what do you do with the cash? What do you buy instead which is as safe, and gives you reasonable return.
This has been a permanent conundrum for bond investors, particularly Private Clients.
So what should you do as a Bond Investor?
The first point to be clear about in a rising rates environment is that longer maturity bonds will be hit harder by definition, in terms of price fall. A typical yield curve, particularly in times of rising rates, will be upward sloping, which is natural as the risk premium of uncertainty will be higher the further out you look.
When rates move up quickly, as it is likely will be the case in this cycle, the prices of longer maturity bonds drop the fastest and farthest. So the first rule should be to cut short the duration of the portfolio, replacing long term bonds with shorter duration bonds.
The second point is that when rates go up fast, while it is a signal of improved economic activity, High Yield bonds, which reflect higher credit risk, are far more vulnerable. There is a good reason why these bonds have a lower credit rating and are “High Yield”. It is because they are not as healthy as equivalent higher rated counterparties. By definition, this means that their cost of borrowing is higher to sustain their business. So when rates go up, their cost of borrowing also goes up, making it more difficult for them to be profitable.
The end result of this vicious cycle is that these issuers are more likely to miss coupon payments and eventually default on their bond repayments.
As a Bond Investor, by staying invested in High Yield bonds in a rising interest rates environment, you multiply your chances of losing your capital.
Re-investment risk at this point starts looking like a small price to pay in comparison.
The Last Word
Interest Rate increases are not a bad thing. It means the gloom of a post GFC world may finally be giving way to some faint rays of light. Rates permanently at zero are unsustainable, and at some point the world needs to come back to normalcy. This looks imminent now, and for Bond Investors struggling to find answers, this piece has hopefully been of some help.
The message I convey is this – Don’t stop investing in bonds, but invest in shorter tenor bonds, in better rated bonds, and in issuers you are comfortable with. Don’t chase yield without considering these factors, because while you might be a “Buy and Hold” investor, when the defaults happen, what you “Hold” will be worth far less than what you paid, and the comparative difference in yield between that and a safer bond (which you considered at the time of purchase), will be the least of your concerns.
To monitor your bond portfolio, visit the bondevalue webpage to register for free beta testing of the iOS App.
Anindya Dutta can be contacted at anindya@thecricketwriter.com
The views expressed here are purely personal, It is not, and should not be regarded as investment advice or as a recommendation regarding any particular security or course of action.
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