I wrote this for CFA Institute and first published it on the Enterprising Investor.
The prospect of rising interest rates has been discussed for long enough that every investor on earth ought to be ready by now.
Of course, that’s not exactly how it works.
To many in the market, bonds play a nearly sacred role. They are volatility-dampeners in chief, tapped into a portfolio for their ability to mitigate occasional stock market jitters. Whatever else one thinks about them, their contractual interest and principal payments make them a nice asset to have around in a risk-off moment.
At least that used to be the case.
Last week, Michael Batnick, CFA, described the regime change we’ve been seeing so far this year:
“in the 8 days that the S&P 500 fell at least 0.5%, bonds declined in all but 1 of those days. I would expect this number to come down as the year goes on, but finishing above 50% would not be unprecedented. In 1999, stocks fell at least 0.5% 79 times, and bonds fell 48 of those 79 days.”
So: What’s Happening?
There’s only one place to start: The interest rate environment has materially evolved.
U.S. Yield Curve: pic.twitter.com/q6LU63HaYX— Michael McDonough (@M_McDonough) February 27, 2018
As I listened to Ben Bernanke interview Janet Yellen recently, it was hard not to see their era in sepia tones. Things have definitely changed.
We’re worried about the economy being too good now. Not, like, ending. As was the fear for a stretch of Mr. Bernanke’s tenure.
And that means it’s time to hike.
The market seems to have noticed this slight difference in the tone of their successor at the US Federal Reserve, Jerome Powell.
Investors now handicapping most hawkish Fed since 2010 following this afternoon's release of the January FOMC meeting minutes pic.twitter.com/F4tOcbBreG— 博思乐 (@boes_) February 21, 2018
Did I say “market”? I meant markets.
Powell triggered quite the move in real yields, which had some passthrough on recently relative resilient EM FX. pic.twitter.com/ygdz6cKLoN— Mats Glettenberg (@MatsGlettenberg) February 27, 2018
The outlook doesn’t seem so great for bond prices, and they haven’t looked this good as a financing alternative in more than a decade.
If these agreeable conditions persist, one imagines that the observations offered by Martin Fridson, CFA, on forecasting fixed-income default rates will come in handy to a healthy proportion of our readers.
Now, none of this means bonds are devoid of appeal. Some asset owners are prohibited from owning anything else. And bonds have held central roles in diversified investment portfolios since what feels like the beginning of time.
Now at the lowest gap between the costs of equity and debt since 2007 pic.twitter.com/y3anaUJkye— David Schawel (@DavidSchawel) February 24, 2018
But, to state the obvious, rising rates are a headwind for bond prices.
And an era just ended at the Fed. We’re likely to see a few spillovers.
If interest rates were just rising in a parallel shift, all of this would be less of an issue.
Stanley Kogelman discussed the consequence of a parallel rise in the yield curve with colleague Pat Light a few years ago, and offered a recipe that may still suit a material proportion of readers:
“if you are concerned about rising rates and you aren’t convinced that you can perfectly time duration adjustments to your portfolio, you should be more comfortable sitting back and assuming that over the course of time, you’re going to get the initial yield or the initial rolling yield of the portfolio that you anticipated.”
Maybe it’ll work out, but the curve is flattening as it rises. And as usual with this sort of thing, there’s no shortage of reasons why.
The Treasury department’s recent refunding announcement, which reflects increased issuance for every maturity especially the 2- and 3-year, combined with #Fed rate hikes, will support further bear flattening of the #yieldcurve. https://t.co/HwvV6FynMy pic.twitter.com/X0yMVkjaPX— Scott Minerd (@ScottMinerd) February 21, 2018
The good news for diversified investors is that maybe the selloff is happening bullishly.
Great minds from BoAML (led by Savita Subramanian) showing that its the shape of the yield curve (2yr-10yr) that matters to equity market performance, not just the level of the 10yr. pic.twitter.com/Rfi9QoDE6Y— Frances Donald (@francesdonald) February 25, 2018
And for those readers who, like me, happen to be based in the United States, it bears mentioning that we are fortunate to have spreads available domestically in the first place.
And of course, the US capital markets are the world’s largest, but they’re not the only game around.
So our Continental colleagues aren’t entirely out of luck. They can harvest a pretty significant spread by looking overseas.
Fancy a trip to Brazil?
Itau: "Brazil’s local yield curve remains one of the steepest in the world. The market currently prices in that rates will be more than 300bps higher in 3 years relative to today, which we believe is excessive premium at this point."
"We recommend receiving DI Jan21 at 8.78%." pic.twitter.com/ozYxKx2gUd
— Felipe Rezende (@F_Derezende) February 26, 2018
Absent a trip to Latin America, there are a few other steps you can take to get ready for this environment. CFA Institute members can get a quick refresher through our one-hour module on” Yield Curve Construction, Trading Strategies, and Risk Analysis.”
There are also some provocative observations in the CFA Digest summary of a Journal of Fixed Income paper, “Profiting from Mean-Reverting Yield Curve Trading Strategies.” Here’s how Gerard Breen, CFA, described how a few different strategies performed from 1973 to 2004. The bold emphasis is mine.
“The results suggest that for strategies pursuing mean reversion in the absolute level of yields, neither the strategy based on mean reversion of average yield levels across the curve nor that based on yield levels at individual maturity points can offer consistently superior returns. For strategies pursuing mean reversion in the slope of the yield curve, the authors find that trades involving mean reversion across the yield curve cannot offer consistently superior returns, although, conversely, those involving mean reversion between just two adjacent points on the yield curve can. For strategies pursuing mean reversion in the curvature of the yield curve, both trades involving curvature across the curve and those involving the curvature of just three adjoining points on the curve are found to offer consistently superior returns. Finally, the authors find that the most consistently profitable and statistically robust of all the strategies is that which pursues mean reversion of the slope between two adjacent points of the yield curve.
Best of luck out there, and thank you for reading.
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