Market Instinct

Our goals are helping you select well-reasoned investment opportunities and growing your business. To do this, our team is more than happy to share our thoughts. Please read, share and enjoy!
RSS Print

Interest rates appear to be on the rise, an already ugly landscape just got a whole lot more horrid for many. Are you and your clients prepared? Are your investments protecting your clients from the downside of interest rate exposure while offering the upside potential of flexible security selection?

Using the Bloomberg Barclays U.S. Aggregate (Agg.) as a proxy, investors are receiving historically low yields while exposing their portfolios to historical high levels of interest rate risk. As of 9/30/2016, the Agg. had a yield to worst (YTW) of 2.12% and a modified duration of 5.8 years, resulting in one of the lowest YTW/modified duration ratios of 0.37 in recent history.

1-bloomberg-barclays-us-aggregate
Source: Barclays

Interest rates have generally been falling since September of 1981, with the 10-year Treasury peaking around 16% and hitting a low of approximately 1.4% in June 2016. While this time period may represent the greatest fixed income “bull market” in our lifetime, the fixed income markets have been anything but “normal” since the Great Recession of 2007-09.

10 Year Treasury Constant Maturity Rate
Source: Board of Governors of the Federal Reserve System (data 1/1/1981-11/16/2016)

To fight the recession, the Federal Reserve (Fed) tried to stimulate the economy through the use of expansionary monetary policy. This involved the Fed buying short-term government bonds to lower short-term market interest rates, which ultimately resulted in a federal funds rate cut all the way to zero (officially 0.00-0.25%). This method of stimulus no longer worked when interest rates reached zero. The federal funds rate remained at zero until December 2015, when the Fed raised the target range by 0.25%.

3-federal-funds-target-rate
Source: © 2016 MoneyCafe.com

To further aid the struggling economy, the Fed embarked on the first of four rounds of “quantitative easing,” the monetary experiment commonly referred to as QE. It is generally used when other, more standard, monetary policies have become ineffective (as described above). Basically, a central bank implements a QE program by purchasing financial assets from commercial banks and other financial institutions, thus increasing the prices of those assets and lowering their yield (prices and yields have an inverse relationship), while concurrently increasing the money supply.

4-monetary-phenomenon
Source: Bank of England (U.K.); U.S. Federal Reserve (others); The Wall Street Journal

Typically, these assets are longer maturity, thereby lowering longer-term interest rates further out on the yield curve. Due to the global nature of our financial world, other foreign central banks have had to follow suit, decreasing interest rates and implementing their own QE programs in an attempt to boost economic growth. This has caused international interest rates to be arguably even more artificially depressed.

However, the interest rate environment looks a little different since the U.S. presidential election.

 

Snapshot of Our Low-Yield World

Prior to U.S. Presidential Election Post U.S. Presidential Election
Country 2-Yr. Maturity 5-Yr. Maturity 10-Yr. Maturity
United States 0.88% 1.34% 1.85%
Germany -0.64% -0.40% 0.17%
Italy -0.06% 0.48% 1.53%
Spain -0.20% 0.17% 1.19%
Japan -1.18% -0.21% -0.07%
Switzerland -1.18% -0.82% -0.42%

Source: Bloomberg as of October 27, 2016

Country 2-Yr. Maturity 5-Yr. Maturity 10-Yr. Maturity
United States 0.99% 1.67% 2.24%
Germany -0.62% -0.31% 0.35%
Italy 0.11% 0.97% 2.15%
Spain -0.12% 0.45% 1.57%
Japan -0.23% -0.16% -0.02%
Switzerland -1.15% -0.68% -0.16%

Source: Bloomberg as of November 14, 2016

Breaking Down Sovereign Debt
Interest Rate Ranges

Prior to U.S. Presidential Election Post U.S. Presidential Election
nov4-v22x nov15-v22x

Source: Bloomberg

 

As you can see from the charts and graphs above, some drastic changes have occurred in the bond market since the surprise win of President-elect Donald Trump. U.S. Treasury yields increased as did many of their international counterparts. According to the statistics listed above, between November 4 and November 15, worldwide debt with negative yields plunged 6.4% following Donald Trump’s upset win. In contrast, worldwide debt yielding more than 2% increased 77%, though still only represents 12% of total sovereign debt.

President-elect Trump’s plans to jump-start the U.S. economy caused a significant selloff in longer-term treasuries. Below, using the U.S. 10-year Treasury as a proxy, you can see the dramatic increase in yield from November 8 (Election Day), 1.855%, through November 17, 2.303%, an increase of approximately 24%.

U.S. Generic Govt 10-Year Yield

u-s-generic-govt-10-year-yieldv2
Source: Bloomberg Markets

The bond market reacted to Trump’s proposed agenda, which includes: expected fiscal stimulus in the form of corporate tax reform (individual rates are also expected to decrease), infrastructure spending and deregulation. Rates have also been potentially baking-in concerns about a possible increase in deficit spending, with the Republican sweep and rising inflation expectations. Furthermore, the positive market reaction following the U.S. presidential election has seen Fed rate hike expectations push to elevated levels. The CME FedWatch tool is showing a ~95% chance of a 25 basis point rate hike in December (as of 11/18/2016), while a Bloomberg article written on 11/15/2016 titled Fed Rate-Hike Odds Approach 100% in Anticipation of Trumponomics, said traders now assign a 94% probability of tightening.

8-probabliity-of-a-fed-hike
Source: Bloomberg; © 2016 Bianco Research, LLC. All Rights Reserved

 

Historically, the Fed has placed emphasis on certain metrics: inflation, median household income, consumer deleverage, wage growth and unemployment. All of the metrics listed have either been improving or are deemed as reasonably solid by much of the investment community (evident by the high analyst odds of a hike increase listed above).

InflationCurrent inflation readings are being driven by recent commodity price weakness (i.e., energy). The target by CPI standards for the Fed has been approximately 2%. CPI Core (CPI less food and energy) is above that mark.

cpi

Source: Bianco Research, Data through 6/30/2016

Median Household Income-Great strides have been made since the financial crisis. The upward trend as of late is viewed as a positive.

median-household

Source: Federal Reserve Bank of St. Louis

Consumer Deleverage-Household debt service payments as a percentage of disposable personal income is at its lowest level in over 30 years.

11-consumer-deleverage

Source: Federal Reserve Bank of St. Louis

Wage Growth-Wages have been slowly increasing. While we are not quite at pre-financial crisis levels, the upward trend is a positive, and the metric is moving in the right direction.

12-wage-growth

Source: FRBATL, Haver Analytics, DB Global Markets Research

Unemployment– U3 is the official unemployment rate. U6 unemployment includes discouraged workers, all other marginally attached workers and those workers who are part-time purely for economic reasons. U3 is approaching 2001 & 2007 lows while U6 is approaching a more “normalized” level.

13-unemployment

Source: Bureau of Labor Statistics; © 2016 Bianco Research, LLC. All Rights Reserved

In the fourth quarter of 2015, Janet Yellen, Chair of the Federal Reserve System Board of Governors, and other Fed officials hammered home the message that even after they raise rates, subsequent increases are intended to be slow and gradual. So, with Trump’s proposed agenda and aforementioned possible effects coupled with the Fed’s historical rate hike metrics in positive territory, the table looks set for a possible slow and methodical set of increases in the foreseeable future.

With the possibility of a prolonged rising rate environment, one which hasn’t been experienced since before September of 1981, advisors and investors alike should be concerned. We are entering an environment where many fixed income portfolio managers have never managed money. During the greatest bull market of our lifetime, security selection based on the underlying fundamentals took a back seat to the masses. Fixed income managers simply had to maximize the duration of their portfolios to win, while sidestepping defaults. Duration is a measure of the sensitivity of the value of principle of a fixed income investment to a change in interest rates. If a fixed income security/portfolio has a high duration (duration is measured in years), it indicates an inability to recycle capital as frequently as lower duration investment options. While this is a positive attribute in a falling rate environment, it is a hindrance when rates rise. All else being equal, interest rate changes have a greater effect on bond portfolios with longer durations. Bond prices generally have an inverse relationship with interest rates. Therefore, rising interest rates typically indicate falling bond prices. Below is a simple illustration of various bond portfolios assuming an instantaneous change in interest rates (shift in the entire yield curve) and assuming no change to credit spreads.

Duration Mark-to-Market Illustration, assuming a 50 bps interest rate hike with diverse effective durations:

Bond Portfolio Characteristics Scenario #1 Scenario #2 Scenario #3 Scenario #4
Effective Duration* 2.0 Years 3.0 Years 5.0 Years 10.0 Years
Interest Rate Hike +50 bps +50 bps +50 bps +50 bps
% ∆ in Bond Portfolio Performance -1.0% -1.5% -2.5% -5.0%

*Effective duration is used to approximate the actual, modified duration of a callable bond.

A real-world example, following the election, showing relative performance of the Weitz Core Plus Income Fund vs. its benchmark, the Bloomberg Barclays U.S. Aggregate, as stated above, the U.S. 10-year Treasury increased 24% from November 8 through November 17:

  Modified Duration
09/30/2016
Performance Between
11/08/2016 and 11/17/2016
Weitz Core Plus Income Fund-Inst. (WCPBX) 3.5 Years -1.33%
Bloomberg Barclays U.S. Aggregate 5.8 Years -2.17%

 


Past performance does not guarantee future results. The investment return and the principal value of an investment in any of the Funds will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than the original cost. Average annual total returns for the Fund’s Institutional Class for the one-year and since inception (the Fund’s inception date was July 31, 2014) periods ended September 30, 2016 were 7.04% and 4.60%. The returns above assume reinvestment of dividends and redemption at the end of each period, and reflect the deduction of annual operating expenses, which as stated in the most recent Prospectus are 1.38% (gross) of the Fund’s Institutional Class. The returns above also include fee waivers and/or expense reimbursements, if any; total returns would have been lower had there been no waivers or reimbursements. The investment adviser has agreed in writing to limit the total annual operating expenses of Institutional Class shares (excluding taxes, interest, brokerage costs, acquired fund fees and expenses and extraordinary expenses) to 0.65% of the respective Class’s average daily net assets through July 31, 2017. Current performance may be higher or lower than the performance data quoted. Performance data current to the most recent month end may be obtained at http://www.weitzinvestments.com/funds_and_performance/fund_performance.fs. Investors should consider carefully the investment objectives, risks and charges and expenses of the Funds before investing. The Fund’s Prospectus contains this and other information about the Funds and should be read carefully before investing. The Prospectus is available from Weitz Investment Management, weitzinvestments.com, 800-304-9745 or 402-391-1980. Portfolio composition is subject to change at any time. Current and future portfolio holdings are subject to risk.

Weitz Securities, Inc. is the distributor of the Weitz Funds.


The examples above shows it does not pay to hold long-duration fixed income assets when interest rates rise. An interest rate hike creates mark-to-market risk, when portfolio values decline due to higher discount rates. While long-duration investments worked to perfection over the past 35+ years, it is not going to benefit managers and their clients in a rising rate environment.

While slow and methodical rate hikes are by no means a reason to discontinue your fixed income allocations, it may be wise to reevaluate your holdings. As discussed prior, advisors and investors alike should focus on funds with historical returns derived from security selection rather than the maximization of duration. In addition, a flexible mandate may be important, as it allows the manager free rein to navigate the entire fixed income spectrum to find reasonable risk-adjusted returns. While spreads have generally been uninspiring since the Great Recession, there have been pockets of opportunity as spreads have been occasionally volatile. The most recent spike on the graphs below was due to the uncertainty surrounding energy in early 2016. Investors that were able to take advantage of the spike in energy spreads, while eluding default, were likely handsomely compensated.

creditsights

Source: CreditSights, Data through 9/30/2016

Opportunities, such as the one highlighted above, are generally not frequent in occurrence. In fact, since the election, spreads have generally compressed. In this low rate environment, it is important for managers to be able to swing when reasonable risk-adjusted returns are present. Unfortunately, many mandates don’t allow for fund flexibility, as they are either tied to credit quality or asset allocation constraints.

Last but not least, it is important to take notice of the natural runoff or maturity distribution of the portfolio. The recurring cash flow provides the investment a consistent source of liquidity and affords portfolio managers the ability to reset both interest rate and credit risk through various market conditions. Strategies with significant runoff are most effective in a rising interest rate environment and/or a period of rising credit spreads.

Fixed income portfolios positioned for rising rates require management with low duration, have flexibility to provide diversifying sources of yield and have consistent runoff to maximize the reinvestment of income.

Regardless of your interest rate outlook, bond investing is still an important part of a well-diversified portfolio, as bonds typically reduce portfolio volatility due to their generally low correlation to equity returns. Anjali Pradhan, CFA, put it best on her blog Stability Now! Why Fixed Income Is Still Relevant:

“Even in the best of times, bonds are not expected to be the engines of growth in a portfolio. Their payout is asymmetrical. Active management aside, the best they can do is pay coupons and return principle. In the worst case, they default and you are left with nothing. What they do add is stability to a larger, more diversified portfolio.”

Are you and your clients prepared?

Institutional Investors or Financial Professionals

This portion of our website is designed specifically for financial professionals.  Please confirm that you are, or you work for, one of the following: (1) a registered Investment Adviser, (2) a bank, savings and loan association, insurance company or registered Investment company or (3) any other person or entity that qualifies as an institutional investor.