In an article for our quarterly Capital Ideas newsletter, I expand on the state of the bond market and voice my concern over the level of risk associated with certain fixed income sectors. Highlighted below are points pulled from the piece that detail our thoughts on today’s monetary environment:
- To push investors into riskier assets, policy-makers have held rates artificially low. When the stimulus is finally removed from the system, rates could rise rapidly to the level dictated by true supply and demand.
- The massive amount of monetary stimulus could cause high levels of inflation, which would result in rising nominal rates in the long-end of the yield curve.
Ben Bernanke made famous the term the “Great Moderation” to describe the last 30 years as a time of predictable government policy, low inflation, declining interest rates, and moderate business cycles. This long super cycle most likely ended in 2007 with the crescendo of the financial crisis. Since the last act of the Great Moderation, the Federal Reserve has ratcheted up the printing presses to stimulate the economy with a zero interest rate policy (ZIRP). Over the last few years, we have discussed the current monetary environment extensively in our essays, but in this article, we will attempt a brief exploration into the possible consequences current monetary policy could have for bond investors.
As I discussed in my last article “Young Investors: Missed Opportunity?” risk averse investors have been piling capital into bonds since the last financial crisis. Morningstar recently stated that the “persistent bond-fund inflows feel like a tired old story, except that with each passing month the drama builds rather than dissipates. With yields across many fixed-income sectors either at or near all-time lows, investors appear content playing musical chairs until the day that interest rates tick up and the music stops.” Our concern is that investors might not be aware of, or are choosing to ignore, the level of risk that currently exists in some fixed income sectors.
First, a step back for some of our readers for a “bonds 101” discussion. The golden rule of bonds is that when interest rates go up, bond prices go down. This is because bonds, unlike stocks, are a fixed stream of cash flow. The stated yield on a bond is a discount mechanism that prices future cash payments (coupons), so when the discount factor (yield) goes up, the value of future cash flows is lower in today’s terms. For US Treasury bonds, there are three sources of return: coupon, change in price, and rolling down the yield curve. Mortgages and corporate bonds are slightly different. They typically provide a higher return than Treasuries (known as the “yield spread”), due to exposure to other risks such as default, prepayment, and lack of liquidity.
Our concerns in today’s monetary environment are twofold. First, to push investors into riskier assets, policymakers have held rates artificially low. So when stimulus is finally removed from the system, rates could rise rapidly to the level dictated by true supply and demand. Second, the massive amount of monetary stimulus could cause high levels of inflation, which would result in rising nominal rates in the long-end of the yield curve.
Traditionally, bonds have been viewed as a risk diversifier in a portfolio because one hopes that when stocks “zig” bonds will “zag.” Additionally, bonds are often used to provide a steady stream of income. US Treasuries have also been traditionally viewed as the global standard for risk-free return. Our thinking is that, in today’s historically low rate environment, US Treasuries might actually be the perfect vehicle for return-free risk. For example, if 10-year US Treasury rates were to rise 2 percentage points from current levels over the next year, they would experience a negative 12 percent total return. Under the same scenario, a 30-year US Treasury would lose 28 percent. Given these numbers, a rapidly rising rate environment could easily crush an income-oriented portfolio.
We are not prognosticating a near-term disaster for bond investors. Investors who hold individual bonds and hold them to maturity are not affected by rising rates. Significant losses could result for investors who need to sell a bond prematurely, however. There are techniques for positioning a fixed income portfolio to thwart these adverse effects. They include duration (interest rate sensitivity) management, yield curve positioning, and sector allocation to assets less sensitive to rising rates, such as investment grade credit, mortgage backed securities, floating rate notes, and Treasury Inflation Protected Securities (TIPS). At Fort Pitt Capital, we believe in a well-diversified, multi-sector fixed income portfolio that utilizes active management. Cognizant of our current economic environment, we started adjusting the asset allocation portfolios last year, with a change to the global bond mandate (see the previous article “Bonds Have More Fun”). Look for additional strategic changes in the future, as we seek to build the best all-weather portfolios for our clients.