Bonds are typically viewed as safe havens in portfolios, but we
could be moving into an era where losing money on fixed income is the norm. Investors, particularly those with lower composure1, should be aware of the way bond maths work, and take steps to protect the principal values of their fixed income portfolio.
Residents of the United States, please read this important information before proceeding
There are a few relationships that are essential to understand when investing in fixed income securities, especially for those who are not employing a long term buy and hold strategy. They are: the relationship between yield and price, and the concept of duration and its effect on the price of your securities. It is also wise to bear in mind what has historically happened to both fixed income and equities in a rising interest rate environment. With yields near all time lows, yet rising, investors need to exercise caution in evaluating their fixed income portfolios in order to guard against principal losses.
This essay has been written mostly from a US perspective, but the arguments apply equally to high-quality European bonds such as UK gilts, German bunds and French OATs. To be clear: our worries focus not on the creditworthiness of issuing governments – we doubt any big government will fail to honour its nominal obligations – but on the fact that bonds are expensive, and face potentially considerable mark-to-market risk.
Lesson 1: Higher yields mean lower prices
Fixed income securities carry a coupon which indicates the annual payment an investor will receive in exchange for lending to the government (or company) concerned. Once the bonds are traded in the market, this coupon divided by the price becomes the running yield on the bond. As the price changes, so does the yield the security offers. The movement of yield and price is inversely related. For the past 30+ years, bond holders have been the beneficiary of declining interest rates as Figure 1 shows. Yields have steadily fallen, and bond prices have steadily risen. This has meant stability, and in most cases increases, in the market value of bond portfolios.
Lesson 2: Duration as a measure of sensitivity to interest rates
Duration, measured in years, can be thought of as the centre of gravity of the cashflow attaching to a bond, and is a measure of its sensitivity to interest rate moves. The higher a bond’s duration, the more sensitive it is to interest rate moves, and the more you stand
to lose if rates begin to rise. When interest rates – and issued coupons – have been low, the principal repayment accounts for a bigger share of the cashflow, and duration lengthens accordingly.
Investors who are heavily allocated to fixed income as a safe-haven, or who have stretched themselves in terms of duration, should look carefully at their portfolio
The 10-year Treasury note has a current duration of around nine years. If yields were to fall to 0% from about 1.9% today, investors would make about 17% in price return. Conversely, if yields were to revert to the historic average of 6.6%,2 investors would see the market price of their safe assets fall by around two-fifths. The bond seems to us to face an asymmetric risk profile – one which investors would be wise to avoid. And with yields near all time lows, there is little income to cushion the blow from price declines.
Lesson 3: The history of rising rate environments
With yields where they are, the question is not if, but when will rates rise. In our view, it makes sense to look to prior periods in which interest rates rose to get some insight in to what could happen to a fixed income portfolio. There are two main reasons as to why US yields are at historically low levels: the Federal Reserve has anchored short term rates at zero, and has also committed to Quantitative Easing (the purchasing of Treasury securities) which has kept prices higher, and yields lower, than would otherwise be the case. Low yields in Europe reflect QE by the Bank of England, while the ECB is presiding over a weak eurozone economy and the euro’s ongoing existential crisis.
Figure 2: US Federal Funds Rate
Although yields have been trending down for the past 30 years, there have been periods when interest rates rose. In examining the period from 1970 through today, there were nine instances in which the Federal Reserve raised interest rates at least three consecutive times (denoted by the shaded area in Figure 2). In the table below (Figure 3), we analyze each of them to determine the effect an increase in short-term interest rates had on fixed income and equity markets, as measured by the 10-year Treasury and S&P 500 Index. In most cases, 10-yearTreasury prices were either flat or fell while equity prices rose. Note that intra-period movements in some cases were more extreme than shown for the period as a whole – notably for example in 1994.
In each of these nine instances when the Fed raised interest rates, yields were already significantly higher than they are today. Higher yields give investors more of a cushion against price declines, because the coupon income helps to compensate for losses in the investment’s value. With yields at 2.0% on the 10-year treasury today, it would take a mere 0.2% rise in rates to eat through an entire year’s worth of coupon. The risk is compounded by eroding effects of inflation: you are barely holding on to your purchasing power with inflation running at an average 1.9% over the past 12 months.
Figure 3: Fixed income and equity performance in a rising rate environment
Chairman Bernanke has indicated that he expects US rates to start rising sometime in the second half of 2015. Since then the Fed has put out guidance that it is targeting an unemployment rate of 6.5%, alongside its inflation target of 2.0%. In our view, an increase in rates is not imminent; however, the market typically tends to be in front of
the Fed, so yields on bonds like the 10-year Treasury begin to creep up in advance of the Fed’s move. With private payrolls averaging 216,600 since the start of the fourth quarter and inflation coming in just below 2.0%, it is possible to see that we may get to Mr. Bernanke’s 6.5% unemployment rate target, and rising yields, sooner than 2015.
Investors who are heavily allocated to fixed income as a safe-haven, or who have stretched themselves in terms of duration, should look carefully at their portfolio holdings. This is particularly important for investors who are averse to mark-to-market losses in their safe assets and who do not plan to hold their bonds until maturity. In the current fixed income environment with its asymmetric risk profile, investors may benefit more than usual from having a smart manager in charge. For those sensitive to losses, managing duration for interest rate risk is key; for a buy and hold strategy, conducting thorough credit analysis is imperative. For a complimentary analysis of your bond portfolio, please reach out to your Barclays coverage team. Meanwhile, in our balanced, multi-asset class portfolios we recommend strategically low holdings of bonds generally.