Risks Along the Yield Curve, Part 1

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Kieran Osborne, CFA, Co-Portfolio Manager, Merk Mutual Funds

In an environment with historically low interest rates, fixed income investors have been pouring money into longer-duration securities, substituting 3 and 6 month T-Bills with 10-year Treasures or bond funds. To an extent, this should not be so surprising: the Federal Reserve’s (the Fed) extraordinary monetary policies have resulted in extremely low yields at the short end of the yield curve.

Investors seeking yield have been forced out the yield curve or into increasingly risky investments in an attempt to gain higher investment returns. However, this is not a strategy without risks, both at the individual investor level and for the economy as a whole. Are the Fed’s monetary policies, combined with the government’s decision to issue increasing levels of longer duration debt, having the unintended consequence of stoking the fire for further financial stress?

While many observers focus on the increased risks associated with moving into lower quality, higher yielding instruments, and away from the likes of government securities, often overlooked is the increased risk associated with simply moving out along the yield curve. Fixed income investments become evermore risky the further out the yield curve investors move. Moving from the short end of the curve into similar quality fixed income securities at the longer end of the curve may have a marked impact on the overall risk profile of a portfolio, as we will explain in more detail below. Of course, increasing the exposure to lower quality fixed income securities also implicitly raises an investment portfolio’s risk profile, and should be a key consideration before any such decision is made.

Longer duration fixed income securities may have a greater propensity to cause “black swan” type events, given that they historically display fat tail return distributions and much higher levels of price volatility relative to shorter-duration securities. We are most concerned that the aggregate risk profile of many fixed income investments, and especially those underlying future obligations, may have now increased.

The implications could be potentially disastrous: the likelihood of another financial catastrophe may have risen; many investments that everyday Americans are relying upon provide future financial security may have been put in jeopardy. Now may be the time for investors to consider fixed income investments at the short-end of the yield curve to take advantage of the diversification benefits fixed income investing may offer, while seeking to mitigate interest risk. Investing outside of the US dollar may also prove beneficial, should present dynamics negatively affect US economic stability.

Recent Treasury data tells an interesting story. Over the 12 months through March 31, 2010, the level of T-Bills held by the public has fallen by 9.4%, whereas Treasury notes and Treasury bonds held by the public have increased by 48.0% and 22.9%, respectively. In just one year, the average length of marketable public debt held by private investors has increased by 7 months: from 3 years, 11 months to 4 years, 6 months(1).

There has been a dramatic shift in the term structure of interest rates, as evidenced by changes to the yield curve:

(Click to enlarge)

To a large extent, the changes in public Treasury holdings has been driven by the Federal government’s choice to issue greater levels of longer duration securities. However, the story that these statistics, in concert with the yield curve, paint is very important: for there to be a decrease in the yield of longer duration securities (as depicted above), which infers an increase in price, there would require greater investor demand, all else equal.

But all things have not been equal: the government has issued vast amounts of longer duration notes and bonds, increasing the supply of these same longer duration instruments. When the supply of any security increases, with no increase in demand, the net effect should be an increase in the yield (decrease in price), but the opposite has happened. By implication, these dynamics infer that the level of demand for longer duration fixed income securities has outstripped the increase in supply; investor preference has shifted to longer-dated securities.

Another important observation is that the opposite has happened at the short end of the curve: the government has reduced the level of T-bills outstanding (reduced supply), yet yields have increased (prices have fallen), implying that the demand for T-bills has fallen more sharply than the decrease in supply. The market has actively shifted out of the short end of the yield curve and into the long end.

These trends are also evident in traditional measures of short-duration investments. We have witnessed a reduction in both retail and institutional money fund assets, along with a reduction in large time deposits held at financial institutions:

(Click to enlarge)

Of course, increased perceived risks associated with money market funds, brought about by the Reserve Primary Fund “breaking the buck” in 2008, reducing its net asset value to below $1 due to Lehman Brothers’ (OTC:LEHMQ) bankruptcy filing, may have acted as a catalyst for some investors to redeploy funds further out the curve or into other asset classes. In our opinion, investors may be jumping from the frying pan into the fire.


  1. United States Department of the Treasury

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