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Question of the Week - November 28, 2016

Question of the Week - November 28, 2016

Guest Post - Monday, November 28, 2016

Should we be afraid of bonds?

Interest rates have moved upward to be sure as of late, but sudden moves like this aren't uncommon. What frustrates investors most, of course, is the tendency for bond markets to move in anticipation of possible interest rate-influencing events; at the same time, exaggerated moves that overshoot reality can often reverse themselves just as quickly. The charts below put recent changes in some perspective. The first depicts the long-term interest rate of the 10-year Treasury Note from its peak level in 1981 until the present, while the second shows a past 5-year snapshot of the same series.

Long-term interest rate of the 10-year Treasury Note from 1981 to present Long-term interest rate of the 5-year Treasury Note from 2012 to present

Source: Federal Reserve

Obviously, the tick upward in recent weeks is barely detectable on the 35+ year chart, and it's dramatic but not unprecedented on the 5-year chart, in the whole scheme of things. This is one reminder that interest rates movements can be quick; however, they're also reactive to current conditions and it can take time for a significant trend to develop.

Some investors have no doubt been rattled by some of the recent moves, especially in government and municipal bond markets where there is little yield cushion (compared to history) to offset the negative price impact. In fact, traditional bond funds and ETFs have experienced almost non-stop inflows over the past several years, with investors chasing relatively tempered yields, and reality has to eventually step in. The reality is that over subsequent years (5-7 or so), bonds have tended to provide total returns very similar to their starting yield. Therefore, the bond bull market returns of the past 30 years would be mathematically impossible to replicate, other than yields moving sharply into the negative. Oddly, it's not uncommon to see some financial planning software offering return choices that mimic the last few decades, albeit this looking extremely inappropriate.

Why have rates moved? A few reasons, but higher yields are a natural byproduct of more normal conditions, however, implying stronger growth which can lead to some inflation. Because interest rates have been 'abnormal' for so long, it's instructive to decompose the various parts of how rates come to be in order to help guide future expectations.

(1) First, there is typically a certain amount of short-term 'real' rate embedded. This is the base amount of interest that investors demand in order to hold a bond in the first place instead of things like cash or a certificate of deposit that have no chance of principal fluctuation. Despite their label of 'risk-free', even short-term treasury bills have market values that will change constantly until maturity—the risk is having to sell before that time and not receive 'par'. Over the course of history (since the 1950's, at least), real yield has accounted for a smaller part, such as quarter or less, of long-term nominal 10-year treasury yields—in the neighborhood of 0.50% to 1.00%—but has hovered on the lower end of this range and even fallen below zero at times especially in recent years. Lately, safety is been in such high demand that investors have given up their need for 'real' yield completely. Over the long haul, that isn't normal behavior.

(2) Second, there is a term premium investors require in order to move further out in maturity on the yield curve, because of the uncertainty in being stuck with a fixed rate investment over a longer period. Historically, this premium has represented anywhere from a quarter to a third of overall yield, but can also vary. This positive yield number also helps create an upward sloping yield curve, which is considered 'normal', and consistent with stretches of economic growth. However, the infamous flat or 'inverted' yield curve, where short rates rise above long rates, can occur at various points in time as conditions slow and/or a recession is expected and investors anticipate a central bank to lower short-term rates.

(3) Finally, inflation expectations are the wildcard, and represent the most important component of the rate puzzle. Traditionally, inflation has accounted for well over half of historical nominal yield. With any type of security paying a fixed rate, inflation coming in lower or higher than expected affects the long-term attractiveness of that particular rate. If inflation ends up being lower than initially assumed, the higher rate earned is quite welcome; but if inflation overshoots, investors are left with a smaller-than expected real return as inflation eats up the rest.

Inflation remains the wildcard this time, too, with recent year-over-year CPI still running low, but the oil price declines of previous years are now rolling off and rates are now adjusting upward to the Fed's target of 2% or a bit higher. Now, with a Trump administration coming in and raising discussions of infrastructure spending, fiscal deficits and stronger growth, inflation expectations have ticked upward, which has been a catalyst for rates rising more recently. Despite these 'hopes', though, there are continued demographic and global growth headwinds that could still keep rates relatively contained, not to mention technical demand factors from foreign buyers (as U.S. rates are far more attractive for bond buyers compared to those in Japan and Europe), as well as a stronger dollar, which can interestingly act as a tempering influence on imported inflation. The Fed has also been quick to reiterate that while higher rates are increasingly appropriate, the pace of normalization could remain at a measured pace as to not disrupt underlying economic growth dynamics.

It's also important to remember that while long-term bonds have always demonstrated a great deal of interest rate risk, shorter- and intermediate- maturity bonds offer far less duration exposure—so experience less dramatic price shifts. When the media talks about a 'bond collapse', the data often used is based on the long-term treasury (and frequently the 30-year at that, which can experience extremely high sensitivity to rate moves, as in a +/- 20% price change per a 1% change in rates). And no doubt, the results of a sharp rate increase on these types of bonds can be shocking to investors that equate 'government' with 'safe'. While very long bonds do offer compelling diversification benefits when pared with stocks (they're one of the best, due to the 'flight to quality' effects that often prop them up when stocks decline), yield-oriented investors over the years haven't given up a lot by shortening durations from the very long segment to the intermediate segment—capturing a good percentage of available yields while offloading substantial interest rate risk.

Being invested in 'credit', such as corporate bonds of various types, can offset some of this interest rate risk through the sometimes counter intuitive 'spread duration' effect, where credit spreads often widen or contract in often the opposite direction of broader rate moves—which can assist in both yield and total return when broader market rates rise. Foreign bonds offer important non-correlated economic and interest rate cycle cross-currents that can offset domestic rate sensitivity, as well as offer higher yields. Additionally, niche assets such as very short duration floating rate bank loans offer a compelling way to take advantage of rising yields and minimizing the principal damage inflicted upon fixed rate bonds. Long-story-short, just as with a diversified asset class allocation, a diversified bond portfolio with a variety of cross-currents and sub-dynamics offers not only a case for improved returns but also lessened volatility compared to being at the mercy of headline interest rate changes alone.

Read our Weekly Review for November 28, 2016.

Read the previous Question of the Week for October 24, 2016.

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