Risks Along the Yield Curve, Part 2

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

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It is widely acknowledged that longer duration fixed income securities are more susceptible to interest rate risk than shorter duration securities. What is less well known is that longer duration securities exhibit much larger, more frequent movements in price than a normal “bell-shaped” curve would suggest, and may therefore be more prone to causing black swan type events. Investors don’t even need to consider an extreme (albeit possible) future scenario, such as the Chinese or Japanese authorities dumping their US debt holdings, for this to occur. Just consider the historic underlying attributes of the 10-year Treasury:

The annualized price volatility of 10-year Treasuries has historically been much higher than short-term T-Bills. The following chart depicts price volatility over two separate timeframes: leading up to the recent financial crisis (12/31/1999 – 06/30/08) and since its onset (06/30/08 – 06/30/10):

(Click to enlarge)

Research conducted by the Federal Reserve Bank of St. Louis found that 10-year Treasury prices exhibited much wider tails than would be expected by a normal distribution, commonly referred to as “fat tails”(2). The research analyzed the volatility of movements in price of the 10-year Treasury bond over a period of more than 25 years.

The results indicate that investors may be subject to significant interest rate and price risk when investing in longer duration securities. It found that there are 16 times more price changes in excess of 3.5 standard deviations than expected with a normal distribution. Furthermore, whereas changes in price greater than 4.5 standard deviations would occur only 7 times in a million under the normal distribution, the findings showed 11 changes in 6,573 observations.

One only needs to look to the recent financial crisis as an example of how fat tail events can wreak financial havoc if not properly addressed as part of a comprehensive approach to risk management, and that is where the problem may lie. We remain skeptical that many of those who have moved out along the yield curve have the sophistication needed to properly manage the increase in risk profile of their underlying investments.

More concerning is that many may be the institutions in charge of managing assets anticipated to provide future income streams and financial security for many working class Americans: during the 12 months to March 31, 2010, life insurance companies increased holdings of Treasury issues by 27.1%, private pension funds increased their holdings by 59.4%, state and local government retirement funds increased holdings by 20.9%(3). Should these institutions fail to meet their objectives, it could potentially precipitate a massive hit to the US economy and financial system, and a collapse in the US dollar.

Over this same timeframe the household sector increased its holdings of Treasury issues (outside of non-marketable savings bonds) by a whopping 72.8%, while commercial banks increased their holdings even more, by 115.4%(4).

Not only may have the Fed’s policies contributed to an increase in the risk profile of investments throughout the economy, but it may also have driven the prices of long-term bonds towards bubble territory. Moving further and further out the yield curve appears to have become an evermore-crowded trade. Should we witness a substantial reversal in sentiment, the risk of large movements in price may be compounded, as many investors scramble to exit their positions. A significant inflationary shock to the system may prompt such a reaction; a very real threat in our opinion, given the vast amounts of money the Fed has been printing.

At some point, the deteriorating public finances of the US government may eventually force investors to reevaluate the rate at which they are compensated for holding US debt obligations. The US fiscal situation has deteriorated significantly, yet the rate the government pays to issue debt has fallen. While the rest of the world is tightening the hatches, imposing fiscal austerity measures, there is little evidence of a concerted effort to rein in government spending on either side of the aisle in the US.

If the US fiscal situation continues to worsen, debt of foreign governments with similar maturities may become comparatively more attractive. If and when the dam breaks, many investors could be in for a rude awakening: this is likely to put upward pressure on rates in the US, causing bond prices to fall and may put renewed pressure on the US dollar should investors move money offshore.

There is a high likelihood that the risk profile of commonly considered “safe” investments – high quality fixed income – has actually deteriorated on aggregate, throughout the economy, by virtue of extremely low rates brought about by the Fed’s monetary policies. In our opinion, investors should be mindful of the potential risks associated with investing in longer-duration fixed income securities, especially if they harbor concerns over inflation or rising interest rates globally.

As interest rates rise, fixed income securities typically fall in value: the longer the duration of the security, the greater the fall in price. Investors may want to consider diversifying internationally to protect against the risk of these scenarios playing out. Many short-maturity international government debt instruments already pay much higher rates than the very low rates available at the short end of the curve in the US Indeed, we have witnessed many international central banks raising interest rates recently. As such, investors may want to consider investing in international fixed income at the short end of the yield curve.


  1. Federal Reserve Bank of St. Louis Review, March/April 2005, 87(2, Part 1) pp. 85-91
  2. Federal Reserve Board of Governors, Flow of Funds Table L.209
  3. Federal Reserve Board of Governors, Flow of Funds Table L.209

Disclosure: No positions