Don’t Play in The Street
Bond Rates Rising?
When will rates rise? This question has been discussed and analyzed ad nauseam by financial analysts, economists and everyday investors since the depths of the financial crisis. What many may not realize is that we have been here before. As the graph below illustrates, after the Great Depression short-term rates remained below 1% for over 15 years; today we are in year seven.
Although the consensus is a 30% chance of a hike in September and a 60% chance in December, some don’t believe that the Fed will raise interest rates anytime soon. Mark Grant, Managing Director of Southwest Securities, is on record as saying, “They (the Fed) have stated and stated and stated that any decision to raise rates will be highly data dependent and the data they presented us, a significant downturn in their expectations for the economy, does not induce me to think they will raise rates anytime soon.” The data points Grant was referring to were a 26% decline in U.S. growth since March 2015, muted inflation and highly suspect unemployment numbers. Jeffrey Gundlach, Founder and Chief Investment Officer of DoubleLine Capital, agrees that the Fed will take longer to increase rates than market consensus believes. “The Fed wants to see more permanent traction from economic data rather than this on-again, off-again type of data that we have been getting,” said Gundlach. He solidified his point by citing data from Bianco Research, “Covering eight instances when the Fed raised rates at least three times…Nominal GDP growth was never lower than 4.9% when the Fed started raising rates; it is 3.9% now. The CPI (consumer price index) was 3% or higher; now core CPI (CPI minus energy and food prices) is 1.8%. The output gap (a measure of manufacturing excess capacity) is a lot larger than it has been in the past.”
While economists and tenured portfolio managers alike don’t know exactly when rates are going to increase, we can all agree that at some point they will. When they do, we will be entering into an environment that is much different than the previous 30+ years. Since September 1981, the bond market (as illustrated by the 10-year Treasury graph below) has been in a secular decline, providing the greatest bond bull market we may ever see.
While there have been periods of rate increases between September 1981-present, many managers have never managed money in an environment with an extended period of rising rates. Over the last 30+ years, bond portfolio managers succeeded by being fully invested and purchasing long-duration bonds. While this investment style worked to perfection in the recent past, it is not going to benefit managers and their clients in a rising rate environment. Why? All else being equal, interest rate changes have a greater effect on bond portfolios with longer durations. The illustration below calculates the expected impact on various bond portfolios assuming an instantaneous change in interest rates (shift in the entire yield curve) and assuming no change to credit spreads. This illustration shows it does not pay to hold long-duration fixed income assets when interest rates rise: this type of environment creates a mark-to-market risk, when portfolio values decline due to higher discount rates.
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%|
So how should a bond portfolio be positioned today considering all the uncertainty around interest rates? At Weitz, we believe that it is important in today’s environment to have reasonably low duration and plenty of “dry powder” available to take advantage of a rising rate environment. Beyond duration, it is important to understand the maturity distribution of the fund, as capital will be needed to invest at higher yields (preferably without having to sell existing holdings). All things being equal, a portfolio positioned as such should bode well allowing for reinvestment at higher incremental yields over the next several years.
All investments are subject to risk, including the possible loss of the money you invest. Past performance does not guarantee future results. There is no guarantee that any particular asset allocation, or mix of funds, or any particular mutual fund, will meet your investment objectives or provide you with a given level of income.