"Who earned it? Eh? I thought so. Your father. You stand on dead men's legs. You've never had any of your own. You couldn't walk alone between two sunrises and hustle the meat for your belly for three meals. Let me see your hand…Dead men's hands have kept it soft." - Wolf Larsen, The Sea Wolf
Like Humphrey Van Weyden, the protagonist of Jack London's, The Sea Wolf, Treasury investors have been the recipients of a legacy of good fortune over the past thirty years. The actions of former Fed chairman Paul Volcker to break entrenched inflationary pressures, combined with disinflationary factors such as the computer and internet revolutions and the entry of billions of new workers into the global workforce, have provided the tailwinds for a 30-year downtrend in Treasury yields (see chart below).
However, rough seas may be ahead. Real yields on the benchmark 10-year Treasury note - or the 10-year yield minus expectations of future inflation - are the most negative they have been in the last 50 years. The 10-year TIPS rate - which reflects real yields, plus an illiquidity premium - is similarly negative (see chart below).
While negative real yields are an indicator of heightened risk in the Treasury market, they do not necessarily mean that Treasury yields are going to rocket higher in the near term. Indeed, negative real yields can either resolved through increases in Treasury yields - like in the 1970s - or decreases in inflation expectations (and yields), like in 2008 (see chart below).
While a deflationary shock, lower inflation expectations and lower yields are possible in the near term, I believe that rising yields, amid less rapidly rising inflation expectations, are most probable over a 5 year horizon. After explaining why, I present some charts on areas of the credit market that may offer relative value and ideas for fixed-income positioning in a rising interest rate environment.
Note: I pulled the data for all of the charts in this article from the St. Louis Fed's wonderful new FRED add-in for Excel. It allows users to access a wealth of data - which they previously needed to pull series-by-series - automatically through a dead-simple interface. Bravo!
Inflation vs. Deflation
The biggest challenge to inflation in the short term is velocity of money that continues to drop like a rock. The velocity of money is calculated as the annualized nominal Gross Domestic Product divided by a measure of the money supply. For this analysis, I use M2, which broadly includes the monetary base, demand deposits (checking accounts) and time deposits (savings accounts). Velocity, which basically measures the number of times a given unit of the money supply "changes hands" to produce the nation's output, increases during periods of credit creation and wealth expansion and decreases during times of wealth destruction (e.g. Asset bubbles popping) and deleveraging. M2 money velocity peaked in 1997 at an unheard-of 2.15, plunged during the 2002-03 recession, increased as the housing bubble continued to inflate in the mid 2000s, and then began to decline once more in 2007. Despite a brief pause in the decline, velocity has continued to drop and is currently at its lowest levels since the late 1950s (see chart below).
In response to falling money velocity, the Fed has been increasing the money supply to try to limit the damage to economic output and, by extension, employment. The following chart shows dramatic recent increases in M1 money supply - or monetary base plus demand deposits - with annual growth peaking at record levels in 2009 and 2011. M2 growth has also been considerable, though has lagged behind growth in M1, highlighting the current difficulty in transmitting monetary policy to the real economy (see chart below).
The Fed's approach is based, in essence, on the "equation of exchange" in economics, MV=PQ, which can be translated as: (Change in Money Supply) + (Change in Velocity) = (Change in Inflation) + (Change in Real Income). Basically, as the velocity of money plunged in 2007-08, the Fed increased the money supply rapidly to prevent steeper declines in price levels (deflation) or real GDP (depression). After cutting the Fed Funds rate target to a range of 0%-0.25%, the Fed's three quantitative easing (bond purchase) programs and Operation Twist program have been designed to respond to the continued decline in the velocity of money.
However, while some have declared the velocity of money to be "dead," it is likely just sleeping. When it wakes, inflation will increase from currently low levels. Indeed, in the chart below, year-over-year CPI growth (green line) is shown responding to M2 money supply growth (orange line) with a lag of about 2 years and a correlation of almost 0.5 (see chart below).
Another shock to economic output, like the exit of one or more countries from the eurozone, a hard landing in China or the fiscal cliff in the U.S. could cause a further leg down in money velocity and Treasury yields. However, with velocity at its lowest point in more than 50 years and Treasury yields bouncing along the bottom of their enormous downward channel (see chart below), I believe that the odds are skewed toward rising Treasury yields over a 5 year horizon.
Fixed Income Positioning in a Rising Rate Environment
Navigating a fixed income portfolio through a rising interest rate environment requires focusing on asset classes that are less sensitive to interest rates and shortening the duration of the portfolio.
To try to evaluate asset class choices and shed some light on pockets of relative value in the fixed income market, I calculated the spreads between 10-year Treasury note yields (constant maturity) and Aaa-rated corporate bonds, Baa-rated corporate bonds, municipal bonds and 30-year fixed rate mortgages, as well as the "default premium" spread between Aaa and Baa corporate bonds. As noted above, I used data from the Federal Reserve's "H1-Selected Interest Rates" release, available on the St. Louis Fed's FRED data service.
Credit spreads are shock absorbers that can tighten and help cushion the blow of rising Treasury yields during good times or, of course, widen and reduce the benefit of falling Treasury yields during bad times. I chart each spread and overlay a long-term rolling average and +/- 1 standard deviation bands to provide perspective on whether the spreads may be cheap (overly wide) or rich (overly tight).
Corporate Bonds: As of September 26th, 2012, Aaa-rated corporate bonds - the highest rung of investment grade, equivalent to S&P's "AAA" rating - were trading at a spread of 1.69% over 10-year Treasuries, or 0.9 standard deviations above the long-term rolling average spread. On the other end of the investment grade spectrum, Baa-rated corporates (equivalent to the "BBB" rating) were trading at a spread of 3.03% to 10-year Treasuries, or 0.96 standard deviations above average. Both spreads have been fluctuating around the upper-1 standard deviation band for about three years now, after their massive financial crisis spike, and suggest the potential for further tightening going forward as the crisis risk premium gradually decays (see charts below).
The default premium - or spread between the Aaa and Baa-rated bonds - was trading at 1.34%, which was 0.87 standard deviations above average. This points to the ability for lower rated investment-grade and higher-rated high-yield bonds (e.g. Ba/BB) to outperform (see chart below).
Investors can gain exposure to the investment grade corporate bond market through the iShares iBoxx Investment Grade Corporate Bond Fund (LQD), which has a duration of 7.6 years, average credit quality of A, a 12-month yield of 3.9% and a 0.15% expense ratio.
With respect to corporate bonds, Ploutos wrote an excellent article in SeekingAlpha on the benefits of BB/Ba bonds - the highest rung of high-yield - over BBB/Baa bonds. High yield exposure can be gained through the iShares iBoxx High Yield Corporate Bond ETF (HYG), which has a 42% allocation to BB bonds (and 42% to B), a yield of 6.86% and a 0.50% expense ratio, or the SPDR Barclays Capital High Yield Bond ETF (JNK), which yields 6.94% and has a 0.4% expense ratio, though allocates 36% to BB and 48% to B-rated bonds.
Mortgages: While the Federal Reserve does not publish yields on the various types of residential mortgage backed securities available to investors (e.g. Agency MBS Pass-Throughs, Agency MBS CMOs, Non-Agency Residential MBS, etc.), they do publish weekly data on the average 30-year fixed mortgage rate. The mortgage rate gives a view as to the credit spread demanded by the market to make mortgage loans, which is one element used in pricing a mortgage backed security. The chart below shows that 30-year fixed rate mortgages were offered - as of the week ending September 20th - at 1.70% over 10-year Treasuries, or slightly under the average spread from the beginning of the data series.
While the spread still has room to tighten toward historical lows, it does not scream value at these levels. And, mortgage backed securities also have the unwelcome characteristic of paying principal more slowly during periods of rising interest rates as fewer homeowners refinance. This characteristic, known as "extension risk," means that mortgage backed securities actually get more sensitive to interest rate changes as rates rise. Ongoing Fed purchases of MBS may counteract this effect by making the credit spread tighten further. However, mortgage spreads are starting at lower levels relative to history than other credit sectors, suggesting less potential for outperformance going forward.
For investors who would like to gain exposure to mortgage backed securities - believing, perhaps, that the Fed's purchase program will cause spreads to tighten to the lower standard deviation band like in previous periods of QE - the iShares Barclays MBS Bond Fund (MBB) is the most liquid ETF offering, with an expense ratio of 0.26%, a 2.5% yield, and a duration of 1.59 years (which can extend during periods of rising interest rates).
Municipals: The spread between the Fed's municipal bond series and the 10-year Treasury yield is currently near its financial crisis peak, closing the week ending September 20th at 1.90%, or 2.4 standard deviations above the average from the beginning of the series (see chart below).
However, muni spreads have been on a clear upward trend since the early 1980s, leading to worries that the current heights may be a value trap, with widening spreads signaling deterioration in municipal credit quality. While the continuing weak economy has certainly strained municipal finances, I don't agree with the value-trap thesis. Indeed, many authors, including from Harvard Business School, have argued that concerns over municipal credit quality are "overblown." Also, detrending the muni spread using its 5-year moving average shows that the spread is still abnormally wide compared to recent history (see chart below).
Investors can gain broad, intermediate term municipal bond exposure through a national municipal bond ETF such as iShares S&P National Municipal Bond (MUB), which has a duration of 6.6 years, a 3.0% yield, and a 0.25% expense ratio.
Conclusion: All of the credit spreads surveyed were far above cyclical lows (or "tights") and had further room to tighten, cushioning the blow of rising Treasury rates. Of these, municipal spreads were the widest compared to history, followed by Baa corporates and Aaa corporates.
Putting It All Together
The relative attractiveness of creditor sectors discussed above has led many large fixed income managers to shun Treasuries in favor of credit-spread products such as corporate bonds, mortgage and asset-backed securities, municipal bonds and foreign government bonds. The following table uses data from Morningstar to compare the most recent reported portfolios of four large intermediate bond funds - PIMCO Total Return, Metropolitan West Total Return, Doubleline Total Return and Dodge & Cox Income - with the Vanguard Total Bond Market index ETF (BND).
All of the managers make major active management bets away from Treasuries. Indeed, while the Vanguard index fund's allocation to U.S. Treasury securities was almost 35%, allocations by the four managers surveyed ranged from a low of 0% to Treasuries (PIMCO) to a high of 14% (Metropolitan West). However, each manager chooses to focus on a different credit sector to make up for their low allocations to Treasuries. PIMCO overweights foreign government bonds, collateralized mortgage obligations (CMOs), municipals and non-agency mortgage backed securities (MBS), Metropolitan West overweights non-agency MBS and asset backed securities, Doubleline focuses on CMOs and non-agency MBS and Dodge & Cox prefers corporate bonds and municipals.
These managers are also reducing the general interest rate sensitivity of their portfolios. Three of the four managers set portfolio duration at least one year below BND's 5.12 years and two of the managers had substantially higher cash holdings than the index fund.
Investors who would like to build similar portfolios (e.g. credit sector exposure with reduced duration) using index products can either use shorter duration versions of the ETFs mentioned above or pursue a "barbell" strategy of owning intermediate or longer-duration ETFs while also holding above-average amounts of cash or very short term securities. The barbell strategy takes advantage of the relatively steep yield curve, which typically normalizes when yields on longer-dated bonds rise less than shorter-dated bonds (see chart below). Holding longer-duration securities and cash can result in a yield pick-up while achieving the same average duration as a lower duration portfolio.
Investors can also hedge longer duration portfolios - or tactically bet on rising rates - using iPath ETNs with returns based on rising 2-year Treasury yields (DTUS), 10-year yields (DTYS), and 30-year rates (DLBS). Barclays also has iPath ETNs that benefit when the 2yr-10yr yield curve flattens (FLAT) and steepens (STPP). Note: Read Lawrence Weinman's excellent article on managing interest rate risk using the iPath ETNs for a more in-depth view. Also, Click Here for a link to the iPath Fixed Income ETN prospectuses.
Over the past 30 years, Treasury investors have benefited both from disinflation and from the use of Treasuries as a deflation hedge. However, after a long period of smooth sailing, Treasuries may be in for rougher seas over the next five years. Focusing on fixed income asset classes with less interest rate sensitivity, which also reducing duration either directly or through barbell or hedging strategies, can help your fixed income allocation navigate safely through a period of rising interest rates.
Disclaimer: Bard Luippold, CFA, is Corporate Finance Manager for Meracord LLC ("Meracord"). This article is prepared by Mr. Luippold as an outside business activity. As such, Meracord does not review or approve materials presented herein. The opinions and any recommendations expressed in this article are those of the author and do not reflect the opinions or recommendations of Meracord.
None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results.