In the press recently influential Federal Reserve policy makers are sending strong signals that the period of ultra-low interest rates is over.
In a May 29, speech to the Economic Club of New York, Former Federal Reserve Chairman Paul Volcker said, the QE3 program is like "pushing on a string." And, "The risks of encouraging speculative distortions and the inflationary potential of the current approach plainly deserve attention," definitely sounds like the former Chairman is advising against the present low rate path.
"This is the end of a 30-year rally" in bonds, Federal Reserve Bank of Dallas President Richard Fisher said in comments to reporters on Tuesday night June 4, after a speech in Toronto. Clearly it's over statement, unusual for a Federal Reserve President.
The realization that the interest rate market is about to finally change course may be a hard adjustment for some investors to make. The recent market "realization" that rates cannot stay where they are was a wake-up call that hurt many, particularly investors in leveraged loans, REITs, utilities, telecom large caps and any Treasuries funds 5 years and above in duration. Rates on Treasuries did not move an extraordinary amount - 35 to 50 basis points. That move in a normal market should be considered a minor abrasion, which will heal in due time. But the impact on many investment sectors was dramatic by comparison, loses in basis on the order of 10%.
The prospect of continued moves up combined with over-leveraged positions is why this move hit many investors so hard.
The movement in rates in May reverberated through the most leveraged sectors in the market, and in particular income-yielding sectors. The carnage in some sectors has continued into early June. The question investors should be asking themselves as the clean up begins is what to do at this time. If you sold into the decline, do you re-set or take new positions at higher yields now that a correction has cleaned out more tenuous trading positions? Or if you did not sell yet, do you take profits as the market calms down? Or do you just continue to ride out the storm?
The answers to these questions really depend on your risk tolerance, and also your perspective on just where the market is headed in the future in terms of rates and economic growth. The May jobs report released on Friday morning (June 7) showed 175K non-farm payroll jobs were added in the U.S. economy. The growth prospects did not really change substantially in the past month. We remain in a long-term, slow growth economy. The good news is that economically the U.S. is not currently on a recessionary path.
On the question of direction in interest rates, my view is that any investing scenario that is based a pullback and sustained low rate scenario in the U.S. for the intermediate or long term is wishful thinking. Just look at the issue based on these points:
If the inflation genie Paul Volcker fears is unleashed - higher rates.
If economic growth picks up - higher rates.
Even if economic growth wanes - higher rates, why? Current high valuations are being led by speculative leverage distortions, which the Fed is now being pressured to push back on and curtail.
And lastly, if foreign investors in U.S. Treasuries begin to move money because U.S. Treasury rates are viewed as too low - higher rates? And this is probably one of the biggest reasons the market, not the Fed, will cause rates to rise over the intermediate term.
The odds of lower rates staying low are approaching the zero in the zero interest rate policy. It is time to make sure your portfolio is structured to weather what may be a multi-year rate increase storm.
With this perspective in mind, I will do a deeper dive into strategies that can be used to strengthen your portfolio in a rising rate environment.
Bond Fund Performance
In the month of May, major bond sector performance was poor as the term structure of interest rates moved higher. Overall the near 50 basis point move up in the long duration sector of the yield curve stretching from 5 years all the way to 30 years produces substantial basis level reductions in the net asset values of the ETFs which track the sector:
In a rebound trade, every maturity across the yield curve during the first week of June exhibited some recovery of the May losses. But the bigger loser in the first week of June was the S&P500 (SPY) (until Friday morning as this analysis was released). This reflects an allocation back into bonds from stocks with the downward move.
The one area not exhibiting much of any movement in the rebound is corporate bonds as measured by the (LAG) index ETF possibly reflecting continued outflow during the week. Over the term structure of interest rates the LAG fund is lower in duration than the 10-year Treasury, but provides an equivalent yield. It is likely to perform better - lose less, in a rising rate environment.
The data on bond ETF performance (SHY) (IEI) (IEF) (TLH) (TLT) recently is not pretty, and the recent interest rate movement is only the first leg of what can be expected to be a multi-year process. The problem bond fund investors have is that they cannot just wait it out and say I plan to hold it to maturity anyway. Bond ETFs like the ones shown in the table above have a component of perpetuity because the fund manager continually rolls over the portfolio into the same asset class and maturity level, creating a constant level of duration that does not shorten through time. At exceptionally low rates, which will rise over time, longer duration funds will show declining net asset values through time until rates stop rising. Fortunately you will receive a higher interest rate in the process, but overall returns will be very low and quite possibly negative. Investing money in this type of asset when you plan to use the money at some point in the future becomes intertwined in a higher order math equation. But it does not take a calculator to understand that if rates rise, investments in bond funds will go down. The only question is will the funds go down less than the alternative if everything is correlated on the way down as it was on the way up. Historically at the early stages of a Fed rate increase, the probabilities are that they will go down more - and I will show data below that show this is happening now.
My advice for those with portfolios that are heavily exposed to longer duration funds is consider a strategy which will better match your duration needs in the future, but maintain the gains you hopefully have accumulated as the Fed has driven interest rates so low.
- Sell the 10-20-30 year duration funds as the market bounces, just as it did in the past week. Park the money in the cash or 1-3 year duration funds, which will not move in principal very much, but will enjoy interest rate rises as the Fed restores more normal rates. These funds will be stable in NAV through time, and the yield on your funds will rise.
- Diversify a portion of the accumulated cash / near-cash position over time into new opportunities which better match your investment time horizon. Use actual bonds with stated maturities as the long duration sell-off takes place to build a portfolio which you will hold long-term. Oddly, as the funds are forced to sell when the masses begin to sell, good quality individual investments always arise. Consider more equity based options if your risk tolerance is high enough. However, I warn that the market in this go around with Fed removal of asset purchases has a high risk of being different than history. The difference being that as rates normalize, the market is actually going to fall as it rises - if that makes sense. A part of the inflation the Fed has pumped into the market through its purchases is going to be withdrawn. At some point the market is going to move down to a more manageable baseline from which it will move up if growth takes hold.
- If you can't hold anything but funds in your account, or cannot work with the complexity of investing in individual issues, the best strategy at this point is to maintain a much higher position of your portfolio in the short-term bond funds (lower risk) to hedge the rate increase, and redeploy a portion into selected assets, which are higher risk equity based funds depending on your risk tolerance.
Structured Bond Portfolios
Although rates are rising and interest sensitive assets are declining in value, one area I do not advise changing at this time is your structured bond portfolio unless it is overweighted in low coupon, long duration bonds. I have recommended throughout this year to use targeted duration in your portfolio. If you have been disciplined and set your portfolio up to provide an income stream from the bonds over time, with bonds maturing at set target dates in the future, then the movement in rates at this point is probably an event that needs to be ignored; it was expected. The only events that change this type of investment strategy are issue specific default risk (low presently). But if your target date for maturity has not changed, then you can still be comfortable that the par value of the bond invested in should be available in full at maturity, and you also enjoy the benefits of a portfolio that is structured to reduce in duration over time - unlike a bond fund. If you have new money to deploy for reasons such as called issues or excess coupon interest, taking on new bond positions really depends on the trade-off between other opportunities available relative to your target date for needing funds from your portfolio. My advice presently is as follows:
- If you are deploying new money or re-deploying called money at this time, you should seek higher quality bonds with lower interest rate risk by looking for longer-term higher coupon bonds with near-term call dates. The benefit of this structure is that the issue may not be called at all if rates rise simply because there is no funding available to get a re-financing done at a lower rate. This strategy does not always pan out, but currently Fed policy movement is a month by month waiting game and this tactic buys time at a decent return. It is also a crowded trade.
- Keep an eye on beaten up sectors for deals that come available. Currently the gold miners and natural resource sectors have decent yields for low investment grade bonds. I expect opportunities to expand over time in the 10-20 year duration window as this year progresses. You must have a set, reasonable YTM expectation, and be ready to take positions when they come available. Many of these opportunities may be quasi-equity plays, such as the (DELL) bond issue which I examine several months ago. In a time when rates are rising, any bond plays of this type remain potentially important longer term holdings in your portfolio to hedge a rise in rates.
- If you are in very high duration, low interest rate bonds, especially zero-coupon bonds that are a mis-match with your target date to maturity, look for swap opportunities which are a better match. Unfortunately in the municipal market it looks like a very crowded trade.
Assessing the Strategy to Move Bond Funds into Stocks
The risk allocation strategy advocated in a rising rate environment historically is to sell long duration bonds and go long the stock market, because technically the stock market is a lower duration holding. This strategy has worked over the last 30 days and last year as the dividend yield plus capital growth has out-paced the loss in basis plus interest yield on the long duration Treasury bond funds.
Jack Bogle, founder of Vanguard Group said in an interview on Thursday:
"There are no certainties in the world, but it would be amazing to me if over the next 10 years stocks didn't outperform bonds," he said.
At the same time, he also said the current Fed policy in the long run "simply will not work." Sounds like another vote that rates must go up.
He is also is fond of saying market timing never works. I don't advocate timing either, but any re-allocation of a portfolio is a timing move, and in a contradictory way he was advising on a move from bonds to stocks, which is a big debate in the market presently.
The question is one of whether in doing so you are jumping from the frying pan to the fire, or making a relative move that will be favorable over time. To help assess this, I have provided some data on the stock market performance over the last 36 days as interest rates moved higher. The data is shown in the 2 charts below.
The first shows stock market data from May 1st through May 30th:
And this chart shows the same stocks and ETFs for the same relative time periods one week later:
In reviewing the performance of stocks in general as measured by the S&P500 ETF against the SPDR Aggregate Bond ETF , and large Cap dividend individual stocks, owning a share of the composite index held up relatively better as interest rates rose rapidly in May. The S&P500 gained 2.36% for the month of May, while the Large Cap interest sensitive sectors took a beating.
But almost one week later, maybe not surprisingly, the issues in the index that were not initially sold off, are, based on the tracking data, beginning to catch up with the Large Cap dividend sell-off. In other words, the rising tide of the Fed that caused all boats to rise is going to cause many of the companies in the index to sink through time, just in a delayed manner between certain sectors.
But being in the large cap dividend names was not nearly as detrimental to overall portfolio value as being exposed to high duration bonds or senior loan closed end funds / BDCs which are highly leveraged or REITs as reflected in this table:
The large cap dividend group as a whole based on the Wisdom Tree Fund is paying a dividend yield of 2.91%, and the performance through time is not significantly different from the S&P 500 when the yield difference is accounted for. If the S&P continues to catch-up with the initial fall with large dividend names as I expect that it will, then the large cap dividend strategy remains the near-term superior strategy over the interim period as risk remains high on the ability of the economy to perform.
But a 2.91% dividend yield is still light in my opinion high enough for an investor facing the risk of rising interest rates. In a rising rate environment, I advise augmenting the average index fund with selected higher yield names because it affords the opportunity to roll dividends over faster into assets priced in a higher rate environment - in other words, get even lower duration in your portfolio with value based opportunities to off-set the threat of higher rates.
Another interesting point that the data shows about the sell-off is that the names with the heaviest selling pressure are big utilities and telecoms. It is potentially a signal that the general economy is going to decline over the intermediate term, and the overall stock market will go down as well. This is a very likely scenario. I would stay away from utility and telecom large cap names until they get to the 5% plus dividend yield level. At this price level they are trading on an equivalent basis with their long dated investment grade bonds, but the option of future dividend increases is still held by the common shareholder. AT&T in the chart above has reached this level and actually was one of the few names that did show a slight uptick in past week. If a generally weak economy is going to continue but rates and rates are going to rise, the non-cyclical pharma names like still appear to have room to run before being fairly valued.
What if Inflation Does Return?
Another scenario that an investor needs to consider in their portfolio at this time is how it will hold up if inflation that has been absent over the past several years, finally does take hold. Uncontrollable inflation is the most likely scenario that would cause more dramatic increases in the term structure of interest rates beyond the current "Fed normalization of balance sheet" phase. I don't have to review in depth the fact that up to now, inflation as measured by the CPI is low, 1.1% for the last twelve months. In a low growth economy in which there is continued wage deflation which I attribute to the years of on-going carry-trade with Japan and other Asian countries, inflation expectations remain low. But the carry trade is being busted right now, and the relationship of weaker yen, higher stocks in the U.S. is also being challenged. This has a lot to do with the new world of Central bank co-ordination that is currently in play, and it could be linked to why Paul Volcker is more concerned with inflation presently. To hedge against rising longer-term inflation names in the chart above like ConocoPhillips , British Petroleum and Total stand out because they are being priced relatively attractively. These names also have not moved substantially from May 30, to June 5, while the broader S&P500 index moved down more quickly, possibly reflecting high duration bond outflows are selectively moving into these securities.
Buying high and selling low is not a good way to play the market. This is the most likely outcome if you continue to buy long duration bond funds right now. Selling high (long duration, low coupon bonds) and buying lower (higher risk, lower duration equities - off-set with higher cash equivalent balances) is the best relative strategy at this time. The data are pointing to a scenario in which equity based assets will have substantially better performance as interest rates rise in the interim timeframe.
The confusing aspect of the upcoming market, however, is that the market adjustment may not be accompanied by a large sustainable rallies in the stock market beyond the level it has already reached. In fact, the market looks may trade flat for the remainder of the year as rates trend up. The run-up in the market this year of over 16% YTD is out of synch with the actual economic statistics. This from my view means that there is a lot of leveraged money which has already purchased the stock market ahead of the anticipated interest rate move up. As money moves from the longer duration bonds, the margined hedged funds and very likely international investment will be the sellers and buyers of the U.S. Treasuries that are sold. But rates on U.S. Treasuries are not currently high enough from a world market standpoint for these trades to unwind. These trades will bust when the relative move between the stock market and bond market in favor of stocks is not maintain. When this happens, it will be a signal for a more substantial stock market correction. For the moment, the issue of portfolio protection from rising interest rates for most investors is the bigger priority.
There are other asset classes with lower duration and higher return, which might also be used strategically as a hedge against portfolio basis reduction as rates rise. They include senior variable rate bank loans, oil & gas royalty trusts, MLPs and selective preferred stock issues. I cannot cover all assets classes thoroughly in one article. I plan to publish more data on this topic in future articles.