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|Reference Indices (February)
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|Barclays US Aggregate
So what do I do with my money?®
"Out of the frying pan, into the fire" describes the behavior of fixed income investors flocking to the front end of the yield curve to avoid bond losses from rising interest rates. Yet, following the March FOMC meeting, it was the front end of the yield curve that showed the largest increases in interest rates. As we highlighted in our year-ahead themes for 2014, "Shorten your duration, but don't own short duration" means that hiding out in the front end of the yield curve won't work for principal preservation strategies that expect zero losses. As the economy strengthens and inflation begins to pick up, the two-to-five year part of the curve should continue to lead increases in interest rates, which could undermine the performance of short duration strategies. With today's historically steep yield curve, where investors hold their interest rate sensitivity is as important as how much. We recommend barbells, ladders and flexible strategies that can maintain the traditional "ballast" benefit of fixed income. These could offset overall portfolio losses in a "risk off" environment, while reducing sensitivity to rising interest rates in the bond portfolio.
Out of the Frying pan, Into the Fire
Negative returns across almost all fixed income sectors in 2013 followed the "taper tantrum" last May-June where 10 year interest rates increased close to 150 basis points. Negative returns of 2% in the Core Fixed Income category (the largest taxable fixed income strategy) and 2.6% in municipal bonds led to these two categories recording the largest outflows in retail mutual funds in 2013 – $121bn in core (8% reduction in assets) and $57bn in municipals (10% reduction), according to Morningstar.
Where did the flows go? Short duration strategies, floating rate bank loans and the opposite of Core Fixed Income (what Morningstar calls "non-traditional") gathered most of the fixed income assets last year, as investors chased yield without duration risk.
With the Fed promising zero rates for years more, following the herd into these short maturity strategies appears to be 2014's safe bet. We have a different view.
These popular strategies exchange one risk—duration risk— for another—yield curve risk. In our view, that is the proverbial jumping out of the frying pan, into the fire.
Yield curve risk is the likelihood that the largest rate increases will occur precisely where (thanks to the Fed's promises) investors today think they are most safe: the two-to-five year maturity spectrum. Investors feel safe there because they expect to be insulated from rising rates in longer maturity tenors given the Fed's promises of zero rates "for a considerable time." Yet this security is predicated on the credibility of the Fed's "forward guidance," a policy that is simply a promise.
The Fed hopes to accomplish easy policy accommodation through "promises" or what they call forward guidance. Former Fed Chair Bernanke explained "[The] degree of accommodation provided by monetary policy depends not just on the current value of the policy rate, but on public expectations of future settings of that rate. The Committee accordingly realized that it could ease policy further—and reduce uncertainty about future policy by assuring the public and markets that it intended to keep the policy rate low for some time, and for a longer period than the public initially expected."1
On March 19, Janet Yellen's first press conference as FOMC Chair hardly assured the public of low rates "for a longer period" and, albeit unintentionally, accomplished exactly the opposite. By specifying exactly what "considerable time" means ("something on the order of around six months"), Yellen accidentally raised the market's expectation regarding when the Fed would begin tightening to a timeframe of about six months sooner than the market expected.
No Longer Just a Matter of Time
More recently, however, the Fed appears to be hinting at a change in its "forward guidance" that implicitly recognizes the failure of the "time based" guidance (highlighted in Bernanke's quote above that anchors long-term rates lower simply by promising a long period of low short term rates). As the date to the first tightening approaches (and based on Yellen's "six month" comment it may now even be within one year), the risk is that we may see larger increases in long term yields that could potentially slow economic activity. Some Fed officials (and other policymakers past and present)2 have begun discussing the arguments that even as the Fed begins tightening, the end point of that tightening will be lower than what "normal" rates would otherwise imply. So far, such viewpoints have yet to make it into the more notable areas of FOMC communications, but such sentiments might be behind part of the outperformance of longer dated yields in March.3
So what do I do with my money?
Reduce exposure to short duration
March's bond market performance (in which short maturity interest rates led the increase in yields) illustrates the perils of strategies concentrating their exposures in the yield curve's front end. Today, investors seek higher income from their cash than money markets or bank deposits offer and lower exposure to rising interest rates than their traditional bond portfolios provide. Short duration strategies work well when the Fed keeps interest rates low. But when the Fed signals a change in its policy from "low for longer" towards "policy normalization" (and in March they accidentally just did that), or when the strength in economic data leads market participants to anticipate "policy normalization," the yield curve should begin to shift toward higher yields led by the two-to-five year part of the curve. Short-duration strategies diverged in March. Funds with more credit exposure benefited from a tightening of credit spreads (the relative price increase of corporate bonds vs Treasuries). The Barclays 1-3 year credit index lost .03% in March, better than the .11% drop seen in the 1-3 year Treasury index or the .30% loss in the 1-5 year Treasury index. Yet the tightening in spreads in March makes these credit investments more vulnerable during the next bout of increasing interest rates.
Reduce exposures to floating rate bank loans
As we outlined in our year-ahead outlook, we hold an underweight recommendation toward floating rate bank loans. One concern is what just played out in March: rising rates in two-to-five-year maturities but no increases in three-month LIBOR. Those trends, if continued, could leave the relative income of bank loans lagging increases in less risky alternatives. And while increased investor demand for floating rate loans might more than offset those concerns, if they do not, prices of loans may need to fall to restore their relative attractiveness.
Note that the year to date performance of loans (+1.20) highlights the continued success and stability of this strategy. Our underweight recommendation—as it did at the beginning of the year—reflects longer run concerns to how that performance may become challenged under a scenario of increasing interest rates led by the front end. As the proceeding sections highlight, such a trend may be underway; hence, our reiteration of recommending reductions to allocations to bank loan strategies when considering longer investment horizons.
Consider "flexible" or "unconstrained" strategies or strategies that can short the front end of the yield curve
The attraction of unconstrained or "flexible" strategies lies in their ability to establish short positions and not be limited to simply owning bonds to mitigate these interest rate risks. Moreover, flexible strategies can even generate positive returns in a rising rate environment by running "short" duration. Another strategy that could generate positive returns in a flattening scenario is to limit the overall duration risks (i.e., not holding large directional views on interest rates going up or down), while profiting from an anticipated narrowing of the gap between long and short maturity yields. As Figure 3 highlights, today's yield curve is historically steep, and the prospects for large declines clearly outweigh big increases. Getting that strategy right to generate positive returns from flattening even as rates rise is one possible attraction of unconstrained strategies in today's environment. But "flexible" doesn't mean infallible and there is no guarantee these strategies will get the call exactly right.
What else can investors do to protect their fixed income portfolios? Consider barbells and ladders
Looking beyond short duration, bank loans and unconstrained strategies, our other recommendation for investors given our interest rate outlook is a "barbell." This strategy moves out of traditional intermediate duration strategies in taxable "core" fixed income (typically around five years of duration) in favor of much shorter overall duration. Investors looking to manage this directly can do so by moving most of their fixed income portfolio assets into two years or shorter strategies, and a portion of the fixed income portfolio in longer duration Treasury, municipals and TIPS as well as high quality investment grade corporate bonds that will help to make up for a portion of the lost yield and maintain duration sensitivity to longer maturity rates. That retains the "ballast" of a fixed income portfolio in the event a major "risk off" scenario were to recur. Were that to happen, it would likely be longer-dated, not short-maturity yields that would rally.
On the shorter end of the barbell, in addition to using mutual funds that maintain maturities of less than two years, investors could also consider using bond ladders. This can include both traditional individual bond ladders, and given the lower individual bond liquidity in today's environment, newer tools such as fixed maturity ETFs. In a rising-interest-rate environment, ladders offer the benefits of maturing principal that can be reinvested at higher future interest rates. Given our concerns over rising rates in the two-to-five year part of the curve, however, we would scale down amounts exposed to the longer end of the bond ladder (i.e., three-to-five year maturities).4
Barbells retain the "ballast"; short duration does not
Overall, in today's environment of rising interest rates, a barbelled portfolio should have a lower duration than the one it replaces. But in an environment of large potential changes in the shape of the yield curve, where investors hold duration is as important as how much duration they have. Though barbelling helps to reduce the sensitivity of a portfolio to rising rates through the shorter leg and makes up for some of the lost income with the longer leg, its key benefit is maintaining exposure to longer dated yields. With today's steep yield curve, longer-dated yields likely decline in a "risk off" environment. The duration exposure of a barbell strategy to these yields (in contrast to a short duration strategy that gives up these exposures entirely) retains the "ballast" benefit of the fixed income portfolio that offsets losses from equity sensitivities in the rest of the investor's portfolio. Though overall income of a barbell strategy may be lower, giving up yield rather than reaching for yield remains a key consideration for transitioning to a more risk-averse fixed income portfolio positioning that favors principal preservation over risking that principal to achieve income.