The Efficacy Of Shorter Term Duration Positioning In A Rising Rate Environment
Many investors seemed to misunderstand my last piece "The Risks Outweigh The Rewards" so I thought I would hash through some of the intricacies of my position, and how to construct fixed income portfolios over a complete investment cycle. Given current risks, and where we are in the interest rate cycle, I believe the greatest risk-reward favors an intermediate to short term position on the yield curve. This will allow the investor to hold bonds to maturity and purchase new bonds at higher rates, either directly or through a mutual fund with professional management.
Let us remember that the reason we own fixed income in an equity centric, global, broadly diversified, long term investment portfolio, is to reduce volatility, and prevent behavioral errors on the equity side of the portfolio such as selling prematurely, which takes you off track from your long term goals. For an investor that has as their objective, growth of principal over the long run, following a strategy which seeks to bring stability to the portfolio during times of market turbulence is generally the best course of action. Therefore we do not want to increase volatility as a reliance on long term bonds tends to do.
When building a portfolio, it is important to remember that there are really only two ways that we can increase the overall return from the Treasury bond sleeve. We can either extend the duration of the bonds, also known as the term premium, or we can reduce their quality, known as the credit premium. Both of these actions, extending the term and lowering the quality, should result in a higher yield fixed income portfolio. However, there are risks that come with following either of these strategies as well. Extending duration increases the convexity of the portfolio, and thus opens one's investment dollars to heightened interest rate risk, through increases in duration. As you can see in the graphic below, convexity cuts both ways so investors need to be careful. Lowering the quality opens investors up to default risk.
When we look at the extended duration funds that exist out there, we see they are very sensitive to moves in interest rates at the long end. This can be positive in that they move up rapidly in the face of falling long term rates, but they also move down rapidly as long term rates rise. This can open an investor up to serious losses from the bond side of the portfolio, which we want to avoid. For those who read my work regularly you know that my objective is, as Warren Buffett tells us, don't lose money. Therefore, as risks have risen in the extended part of the curve I believe investors will fare better following an intermediate to short term positioning on the yield curve, and research is supportive of this stance.
The Economy Remains Weak
It is important for investors to understand that I have not changed my thesis. I continue to believe that the economic fundamentals look weak. Inflation is still sitting far below the Fed's 2% target and velocity on M2 remains at levels not seen since the 1940s. Thus, I do believe in constructing a bond portfolio that takes advantage of the positioning on the yield curve that represents the most value (STRIPS), even as we reduce unnecessary risks across the curve. To illustrate this, I want to look at yield curve positioning through the eyes of the individual investor. To do this I will use a series of funds meant to represent each section of the yield curve.
Yield Curve Positioning Matters
-Vanguard Extended Duration U.S. Treasury (EDV)
Represents the 20-30 Year Extended Part of the Curve
-Vanguard Long Term Treasury (VUSTX)
Represents the 10-20 Year Long Term Part of the Curve
-Vanguard Intermediate Term Treasury (VFITX)
Represents the 4-9 year "belly" of the Curve
-Vanguard Short Term Treasury (VFISX)
Represents the 1-3 year Short End of the Curve.
-SPDR Bloomberg Barclays 1-3 Month T-Bil (BIL)
Represents the ultra-short part of the Curve AKA Cash and Cash Equivalents
We know that in a deflationary environment the most important investments one can have is to first and foremost be out of all debt. The second is to have a portfolio of U.S. Treasury securities and also cash which gains in value as prices fall. If we were building a Treasury portfolio to prepare for deflation with the advantage of hindsight, then we would simply buy 100% 30 year U.S. Treasury STRIPS. However we live in the real world, where there is no certainty about the direction of rates, the economy, inflation, or who the next Fed chair will be. In this environment then we need to construct a portfolio that takes advantage of many different scenarios regardless of what I feel is most probable. This is a more reasoned and logical course of action simply because the risks of being wrong would be far too great-remember you do not want to lose money.
Seeing as the Treasury sleeve of the portfolio is meant to provide stability, we want to reduce the overall risk being taken while still being able to benefit from a big picture view that sees structural challenges ahead for the U.S. economy.
So let's look at two hypothetical portfolios to illustrate this concept:
|Portfolio 1 Treasury Sleeve Allocation||Portfolio 2 Treasury Sleeve Allocation|
|Vanguard Extended Duration U.S. Treasury (EDV)- Represents the 20-30 Year Extended Part of the Curve||65%||15%|
Vanguard Long Term Treasury (VUSTX) Represents the 10-20 Year Long Term Part of the Curve
|Vanguard Intermediate Term Treasury (VFITX) Represents the 4-9 year "belly" of the Curve||0%||15%|
|Vanguard Short Term Treasury (VFISX) Represents the 1-3 year short end of the Curve.||0%||15%|
SPDR Bloomberg Barclays 1-3 Month T-Bil (BIL) Represents the ultra short part of the Curve AKA Cash and Cash Equivalents
By studying the recent past we can get a more generalized view of what the immediate future may hold. So let's explore just the past three year period of time. In that time, Portfolio 1 provides an investor with far more protection from left tail events, but also opens an investor up to more duration risk, and more volatility. It has duration risk of 20.26, meaning for every 1% rise in interest rates, an investor can expect the price of the bond portfolio to decline by 20.26%. Now, while the investor always has the ability to simply hold to maturity, most would fail to discipline themselves to receive a low return on their investment, for the entirety of the portfolio's maturity. For a section of the portfolio that is meant to reduce risk and provide stability, this allocation is doing the opposite, especially if rates rise.
When we look at other metrics like volatility we see that the portfolio sports a standard deviation of 14.0. This volatility is commensurate with equities, and yet the return on this portfolio was only 5.4% during the period, versus 10.77% for the S&P 500 with standard deviation of only 10.07. Therefore, the risk outweighs the reward. Thus, investors would be wise to construct portfolios where you take your risk on the equity side of the portfolio.
Now let's look at Portfolio 2. It is structured very differently from portfolio 1. Portfolio 2 relies more on short term Treasury instruments such as T-bills and much less on Treasury STRIPS and other long term Treasury bonds. Yet it continues to accomplish its goal of preserving an investor's principal, providing a competitive rate of return in a low rate environment, while also reducing volatility in the equity-dominant total portfolio model. When we look at Portfolio 2 we see that it's duration risk is only 7.43, which again means that should interest rates rise by 1% the portfolio would see its value decline by 7.43% --not ideal, but not anywhere near the 20.26% decline of Portfolio 1.
Let's look at volatility and we see that Portfolio 2 has volatility at 4.9, which is much lower than the 14.0 of portfolio 1. Yet even as we were able to produce a portfolio with far less duration risk or volatility, we still were able to produce returns of 2.3% which are not horrible in an ultra low interest rate environment; adding short-intermediate duration corporate credit to this would have boosted the yield even further, but let's leave that out of this discussion for now and focus on Treasury-only portfolios. This 2.3% is even more impressive in that we held 40% of the model in cash and cash equivalents earning close to 0%.
So we can see from these two portfolios that while portfolio 2 only produced a return of 2.3%, it did so with nearly 65% less volatility than portfolio 1. I think it is also instructive to explore how these two portfolios would behave during a left tail risk event such as 2008.
Portfolio 1 would have produced a return of 42% in 2008 -- fantastic! But it is important to also note that much of that gain was given back the next year, as stocks began to rebound and bonds sold off. Portfolio 2, however, with its lower volatility and duration risk, still produced returns during a left tail risk event of 15%, which provided a nice cushion against the volatility of the equity portfolio. Because duration was not extended and volatility was held down, portfolio 2 did not experience the same reversion in 2009. Thus portfolio 2 actually accomplished its objective of being a reducer of volatility far better than portfolio 1 during the combined period. This is largely due to the extreme convexity of portfolio 1, with 65% in extended duration securities which increased its volatility. This works wonderfully in negative equity markets but robs your returns in positive equity markets, if you assume perfect negative correlation.
How to Construct the Treasury Sleeve
As rates continue to rise, I believe it is in an investor's best interests to keep duration risk low, and reduce volatility in their bond portfolio. For investors using bonds simply to reduce volatility this can be done with a simple portfolio of U.S. Treasury securities.
For those who want to manage the portfolio themselves and understand the complexities of yield curve positioning, you can simply buy individual U.S. Treasury bonds; however look out for fees, and markups. This all depends upon your broker's fee structure; some allow for Treasuries to be purchased without a fee.
However, for most investors who do not want to engage in the continuous management of this section of the portfolio, or for whom the expense is too great, simple U.S. Treasury mutual funds will be a better solution. With a mutual fund you are giving up the control premium of having a defined maturity and rate of interest, but you are gaining professional management of the portfolio and relatively consistent duration positioning. It is a matter of preference.
For investors also looking to attain income from their bond portfolio, there are still opportunities within corporate credit. While spreads on high yield debt have also fallen to a level where the risks outweigh the rewards, a small allocation to high yield debt may boost yield and total return, while still providing the overall stability of a portfolio made up of primarily investment grade bonds. For investors looking for a one stop portfolio option, I hold the Baird Core Plus Bond Institutional (BCOIX) fund, which does this very well whatever the size of your portfolio. It also only charges expenses of 0.30% and no loads or 12b-1 fees, making this a very cheap option in the bond space for active management. The fund can own up to 20% in non-investment grade bonds, while holding 80% of the portfolio in government securities and other investment grade corporate debt. It currently yields nearly 3%.
I continue to believe that from an economic perspective there are a tremendous number of risks in the economy, and I do believe that investors would benefit from holding an allocation to Treasury bonds and cash that works for their specific goals. However, I believe they will most benefit from limiting exposure to extended duration and long dated U.S. Treasury securities, and emphasizing a higher allocation to intermediate term, short term, and ultra short term Treasury bonds, notes and bills, as a way to both hedge equity market volatility and provide stability to the overall portfolio model.
It is important that investors keep this section of the portfolio in place. The size of this section of the portfolio should be aligned with an investor's specific goals, but in this age of over-exposure to equity market risk, investors need to think of this section of the portfolio as insurance against the unknown. If you have gotten rid of this section of the portfolio to hold 100% equity portfolios, now may be a good time to re-balance back and follow a principled portfolio management model. Holding sufficient cash and Treasury securities lowers portfolio volatility and ensures an investor can stay on the path towards their long term goals. In my next piece I will look at adding corporate credit to the portfolio and how this affects duration, volatility and portfolio return.
Disclosure: I am/we are long BCOIX, U.S. TREASURY BONDS.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: This article is for informational purposes only and is not an offer to buy or sell any security. It is not intended to be financial advice, and it is not financial advice. Before acting on any information contained herein, be sure to consult your own financial advisor. This article does not constitute tax advice. Every investor should consult their tax advisor or CPA before acting on any information contained herein.