Equities And Equity Funds With The Largest Hidden Bond Risks

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Includes: BDBD, CB, EDR, FRT, FSS, MORN, O, TROW, VLY, WRI
by: AlphaBetaWorks

Summary

Bond yields have been an important driver of equity returns in recent years. They may become even more important as Fed struggles to remove the stimulus.

Yet, hidden bond exposures are often overlooked by equity investors.

Small capitalization stocks and funds tend to have negative bond exposures.

We identify equities and funds that are most exposed to bonds, even after accounting for market, sector, and style risks.

For most of these stocks and funds, bond risk will be the second most important source of volatility and return, after market risk.

Hidden Bond Risk in the Equity Market

This year, some equity investors have experienced volatility and poor performance. The true reasons are rarely understood. Even equity fund managers rarely understand the causes. The hidden bond exposure in stocks and equity portfolios is often the culprit.

An equity portfolio with no bond positions is still exposed to the bond market. The relationship between equity and fixed income markets evolves, depending on the macroeconomic environment; it has been significant lately. Over the past five years, 20% of U.S. Equity Market volatility can be explained by a negative correlation to the U.S. Bond Index:

U.S. Market Monthly Returns Vs. U.S. Bond Index Monthly Returns (2009-2014)

Click to enlarge

Source: abwinsights.com

For example: The 5.4% decline in bond prices explains over a third of the 31% Russell 3000 return in 2013.

Hidden Bond Risk in Small Caps

A less well-appreciated source of additional bond risk is the bond exposure of particular industries and stock types. For example, Size Factor (the difference in returns, net of market and sector effects, between the largest and the smallest stocks) has a significant positive relationship with bonds: Small caps tend to have a negative relationship to bond prices, while the opposite is true for large cap stocks.

U.S. Size Factor Monthly Returns Vs. U.S. Bond Index Monthly Returns (2009-2014)

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Source: abwinsights.com

In 2013, the smallest U.S. stocks outperformed the largest by 9%. The 5.4% decline in bonds explains over half of this outperformance. In short, if you're making an allocation to small or large capitalization stocks or funds, you're making an implicit bet on bonds.

This source of bond exposure is captured by AlphaBetaWorks' Size Factor exposure (beta). This exposure is often overlooked, but a robust equity risk model will identify it.

Company-Specific Bond Risk

Financially levered companies - particularly those with fixed long-term liabilities - have negative exposure to bonds. Any change in interest rates will affect the value of their liabilities and thus their stock prices. For example, Valley National Bancorp (NYSE:VLY), which is approximately 2.5 times levered, has significant short bond exposure. The statistically observed exposure is -1.4x - almost perfectly in-line with its 150% debt load:

Valley National Bancorp Monthly Returns Vs. U.S. Bond Index Monthly Returns (2009-2014)

Click to enlarge

Source: abwinsights.com

Bond performance also captures a number of broad macroeconomic risks: deflation, credit crises, and recessions. Companies that are not financially levered, but are still heavily exposed to these risks, exhibit negative correlation with bonds. For instance, the earnings power of T. Rowe Price Group (NASDAQ:TROW) is sensitive to the faith in capital markets, macroeconomic stability, and investor sentiment. TROW and other asset managers tend to have negative bond exposures. Approximately 20% of the volatility of TROW over the past five years, net of market and sector effects, is explained by bond returns:

T. Rowe Price Group Monthly Returns Vs. U.S. Bond Index Monthly Returns (2009-2014)

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Source: abwinsights.com

Some businesses own a relatively well-defined stream of long-duration cash flows and are structurally similar to bonds. Most REITs, Royalty Trusts, and MLPs have large and statistically significant long bond exposures. For instance, approximately 22% of the volatility of Education Realty Trust, Inc. (NYSE:EDR), net of market and sector effects, is explained by bond price changes:

Education Realty Trust, Inc. Monthly Returns Vs. U.S. Bond Index Monthly Returns (2009-2014)

Click to enlarge

Source: abwinsights.com

Stocks Most Exposed to Bonds

Some stocks with large bond bets and high bond correlations are listed below. These are the bond exposures in addition to market, sector, and style risk - also sources of bond correlation. These stocks will benefit, or suffer, from any large moves in bonds:

Stocks - Short Bond Exposure

Symbol

Name

Residual Bond Correlation

TROW

T. Rowe Price Group

-.45

(NYSE:FSS)

Federal Signal Corporation

-.40

(NASDAQ:BDBD)

Boulder Brands, Inc.

-.40

(NASDAQ:TAST)

Carrols Restaurant Group, Inc.

-.39

(NASDAQ:MORN)

Morningstar, Inc.

-.39

(NASDAQ:HSII)

Heidrick & Struggles International, Inc.

-.38

(NYSE:PPC)

Pilgrim's Pride Corporation

-.37

(NASDAQ:SHBI)

Shore Bancshares, Inc.

-.36

(NASDAQ:ACET)

Aceto Corporation

-.36

VLY

Valley National Bancorp

-.35

Click to enlarge

Stocks - Long Bond Exposure

Symbol

Name

Residual Bond Correlation

(NYSE:EGP)

EastGroup Properties, Inc.

.38

(NYSE:MAA)

Mid-America Apartment Communities, Inc.

.38

(NYSE:NLY)

Annaly Capital Management, Inc.

.39

(NYSE:NNN)

National Retail Properties, Inc.

.40

(NYSE:HR)

Healthcare Realty Trust Incorporated

.40

(NYSE:WRI)

Weingarten Realty Investors

.41

(NYSE:CB)

Chubb Corporation

.41

(NYSE:FRT)

Federal Realty Investment Trust

.43

(NYSE:O)

Realty Income Corporation

.44

EDR

Education Realty Trust, Inc.

.47

Click to enlarge

Mutual Fund and Hedge Fund Volatility Due to Bond Exposure

So how important is bond exposure in practice? The AlphaBetaWorks Performance Analytics Platform regularly analyzes 15 years of portfolio and performance history of approximately 3,000 medium and lower turnover U.S. mutual funds and 400 medium and lower turnover U.S. hedge funds to determine the main sources of risk and return. For hedge funds we analyze long equity portfolios, available from 13F filings, only.

For mutual funds, bond exposure accounted for approximately 0.5% of variance - about an equal contribution to the Value/Growth Factor and the Canadian Market.

Factors Contributing to U.S. Mutual Fund Performance

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Source: abwinsights.com

For Hedge Funds, bond exposure is a more significant return driver, explaining three times more variance. The Bond Factor is the fourth most important risk factor for long hedge fund portfolios, ahead of Value/Growth, Oil Price, and Technology Sector factors. Only the Market, Finance Sector, and Size factors are more influential to hedge funds.

Factors Contributing to U.S. Hedge Fund Performance
Click to enlarge

Source: abwinsights.com

The importance of bond risk to hedge funds is a natural consequence of their fondness for indebted companies and other "cheap call options," often levered bets with embedded short bond exposures. Mind you, this is aggregate data. For many hedge funds, bond exposure is the second most important risk, after market exposure.

Mutual Funds Most Exposed to Bonds

Some U.S. mutual funds with the largest bond bets are listed below. These are the bond exposures in addition to market, sector, and style risk - also sources of bond correlation. Many carry embedded bond bets on the same scale as their AUM:

Equity Mutual Funds - Short Bond Exposure

Symbol

Name

Bond Exposure (%)

LLSCX

Longleaf Partners Small Cap Fund

-101.41

RYPNX

Royce Opportunity Fund

-100.33

HRVIX

Heartland Value Plus Fund

-73.73

HRTVX

Heartland Value Fund

-70.98

LKSCX

LKCM Small Cap Equity Fund

-68.44

VTSIX

Vanguard Tax Managed Small Cap Fund

-60.56

MSSMX

Morgan Stanley Instl. Fund-Small Company Growth Portfolio

-60.54

WCSTX

Waddell & Reed Advisors Science & Technology Fund

-57.40

HIASX

Hartford Small Company HLS Fund

-57.27

RYVPX

Royce Value Plus Fund

-56.93

Click to enlarge

Equity Mutual Funds - Long Bond Exposure

Symbol

Name

Bond Exposure (%)

PRMTX

T Rowe Price Media & Telecommunications Fund

26.69

TEDMX

Templeton Developing Markets Trust

28.34

HCIEX

Hirtle Callaghan International Equity Fund

31.16

WRVBX

Waddell & Reed Advisors Vanguard Fund

33.82

MIEIX

MFS Institutional International Equity Fund

34.27

OPGSX

Oppenheimer Gold & Special Minerals Fund

83.63

CSEIX

Cohen & Steers Realty Income Fund

139.67

CSRIX

Cohen & Steers Institutional Realty Shares Fund

145.57

CSRSX

Cohen & Steers Realty Shares Fund

146.59

TRREX

T Rowe Price Real Estate Fund

154.04

Click to enlarge

Hedge Funds Most Exposed to Bonds

Some U.S. hedge funds with the largest bond bets are listed below. For many of these, bond returns will be the second most important driver of medium-term performance.

Long Equity Hedge Fund Portfolios - Short Bond Exposure

Name

Bond Exposure (%)

ESL Investments, Inc.

-98.81

Harbinger Capital Partners LLC

-86.64

Starboard Value LP

-82.37

Lakewood Capital Management LP

-78.32

Paradigm Capital Management, Inc.

-76.12

Basswood Capital Management LLC

-68.92

Rima Senvest Management LLC

-68.81

Fine Capital Partners LP

-65.84

Palo Alto Investors LLC

-52.35

Greenlight Capital, Inc.

-48.67

Click to enlarge

Long Equity Hedge Fund Portfolios - Long Bond Exposure

Name

Bond Exposure (%)

Cushing MLP Asset Management LP

42.71

Bridgewater Associates LP

42.99

Energy Income Partners LLC

45.24

Baker Bros. Advisors LP

47.29

Kayne Anderson Capital Advisors LP

48.13

SCS Capital Management LLC

49.55

Harvest Fund Advisors LLC

58.20

Center Coast Capital Advisors LP

58.92

H Partners Management LLC

80.39

Atlantic Investment Management, Inc.

81.61

Click to enlarge

Conclusions

  • Hidden bond exposures in stocks and equity portfolios are often overlooked, even by professional investors.
  • Market, style, and industry risk factors influence bond exposures of stocks and equity portfolios.
  • Small capitalization stocks and funds tend to have negative bond exposures.
  • Some equity securities are significantly exposed to bonds, even after accounting for market and sector risks.
  • For many stocks and funds, bond exposure is the second most important source of risk and return.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.