May 11, 2017

Taking the "Fixed" Out of Fixed Income

By Gene Balas

As is obvious to all, yields on government bonds in much of the developed world are low, and we don’t need to repeat the reasons why. Instead, given that the U.S. Federal Reserve is raising rates and will eventually shrink its balance sheet, and the European Central Bank will, at some indeterminate date, taper its bond purchase program, our focus is on what happens next. Or, to put it a different way, what is the risk/return tradeoff of owning bonds in an uncertain environment?

Given so many different variables influence interest rates (e.g., inflation, borrowing needs by governments and corporations, desire of investors to hold bonds, etc.), it might be best to think of what might happen if forecasts go wrong. In that vein, let’s identify some risks and determine whether you are compensated accordingly. The better compensated you are, the more reason to take certain risks.

Are you compensated for interest rate risk?

When interest rates rise, bond prices fall, and the longer the maturity, the more a bond price will typically fall given the same change in interest rates. Investors demand higher compensation for taking this risk. In financial terms, this is called the term premium, and it is basically an estimate of the extra yield you get by holding a longer term bond instead of a series of shorter term instruments for the same amount of time.

Right now, the term premium is about zero, and in the graph nearby, you can see how this measure has fallen consistently over time.

10 year term premium.png

In a simpler measure, one can simply compare the yields of bonds maturing in different periods. In the graph below, we see the yield advantage of owning a ten year U.S. Treasury bond vs. a two year Treasury note, and the parallel advantage of owning a 30 year Treasury vs. a 10 year Treasury bond. As you see, this extra yield for investing in longer term bonds has fallen, as the yield curve has flattened.

30 minus 10 and 10 minus 2.png

Are you compensated for credit risk?

So, if one isn’t highly compensated for taking interest rate risk in longer term government bonds, what about investing in corporate bonds? They do offer a yield premium, or spread, over Treasuries. This spread pays investors for taking credit risk, which is related to a bond being downgraded by rating agencies or, in the worst case, even defaulting. Right now, we also see the credit spread is quite low, looking at the measure for high yield (below investment grade) bonds.

High Yield Spreads.png

With thin spreads, investors’ compensation for taking credit risk is low relative to history. If a bond is downgraded, the extra bit of yield one gets might not offset the price decline of the bond in such an event. (Not to mention the worst case of a company or government defaulting on the bond.)

These are risks, but not necessarily the base case

Having walked you through the risks of what happens if interest rates rise or credit worries mount, what about the base case, the scenario that reflects current conditions projected into the future? Well, there are reasons to believe that low interest rates might be with us to stay, though every forecast is fraught with error, and as a general rule, I prefer not to make explicit forecasts. But what we can say is that U.S. Treasury yields are correlated to the nominal potential growth rate of the economy.

The potential growth rate of the economy isn’t what happened in the past; rather, it’s what the economy might be expected to do, on average and over long periods of time in the future. Some of the basic inputs to this expected potential growth rate are the growth of the labor force (which is fairly easily understood, given demographic trends), and productivity gains (which are harder to forecast and have been low in recent years). And, of course, since this is nominal GDP, another component is inflation expectations, which can be derived from many different sources. Consider the nearby graph that illustrates the correlation between potential GDP and the 10 year Treasury yield.

Potential GDP Growth Rate and 10 year Treasury.png

So, based on this trajectory for lower nominal economic growth, maybe interest rates don’t surge to levels at which they had been in decades past. That means that some investors may be more comfortable with taking some interest rate risk; hence the low term premiums we discussed. But, should those forecasts prove wrong for whatever reason, yields can always defy forecasts.

But what about credit risk?

This is a different animal altogether. Credit spreads surge when economic conditions deteriorate, as seen in the nearby graph of the tremendous parabolic spike during the Great Recession. Even other periods have seen spikes in credit spreads for other events, some that have not necessarily traversed to the U.S. shores, such as distress over sovereign debt in Europe, for example. And specific sectors in high yield can have difficulties, namely energy in the recent past, which can drive the average spreads (what you might find in a typical commingled vehicle) higher. Still, we’ve seen sustained periods where credit spreads have been low. They just don’t always stay that way – and can jump on any unforeseen event.

High Yield Spreads Longer History.png

Conclusion

The point of this discussion isn’t to scare you away from fixed income. The asset class has many valuable features and may belong in many investors’ portfolios. An obvious reason is if one needs income; in that case, you might not be concerned with price fluctuations along the way. Another is that some bonds have, in some instances historically, offered diversification benefits to risks in stocks. Importantly, I’m not making any sort of forecast as what bonds will or won’t do. We can observe, though, that shorter maturity bonds generally have less interest rate risk than longer term bonds, and higher quality bonds generally have less credit risk than lower quality bonds. As we discussed, the tradeoff is a lower yield.

The conclusion is, however, regardless of what bonds do, are you being compensated for the risks you undertake? After all, the reason why I don’t make forecasts is because it’s impossible to predict the future with certainty. As with many things in life, surprises are the only certainty – and that means taking the “fixed” out of fixed income.

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