As the Fed heads into its December meeting, bond managers will once again warn investors to prepare for the potential of QE tapering and a rise in interest rates. While the waiting game continues, it’s time we take a close look at risk-free bonds and decide: are they too good to be true?
Brian J. Machtley, Executive Vice President, Head of Research & Portfolio Management at Cognios Capital.
Historically, debt issued by the United States has been considered “risk-free” due to the fact that there is a near zero chance that the United States will default on its debt (i.e. not pay principal or interest). Even in periods of large government deficits and mounting national debt such as today, the United States is unlikely to default on its debt because the Federal Reserve can monetize the debt (i.e. print money) through various programs such as quantitative easing. However, this does not mean that U.S. Treasuries are risk-free. Investors in Treasuries still face interest rate risk and inflation risk, both of which can reduce the value of bonds.
Interest rate risk arises from the mechanics of traditional fixed coupon, fixed maturity bonds, in that the value of the security falls as interest rates rise. For example, if an investor purchases a ten year bond at face value of $1,000 that pays a semi-annual coupon of $14.50 ($14.50*2=$29.00, 2.90% rate approximately same as the current ten year yield[i]) and interest rates immediately jump to 4% on the day following purchase, which would still be below the long term average ten year Treasury yield of 6.56%[ii], then the value of the bond declines by 15% to $850.51[iii], although it would be highly unlikely for ten year Treasury bonds decline in price and gain in yield over such a short period of time. Interest rate risk is magnified by the Duration of the bond. Simply stated, Duration is the weighted average life of a bond based on the timing and present value of the promised payments. Values for bonds with longer Duration are more sensitive to changes in interest rates. For example, if the bond in the above example were a thirty year bond instead of a ten year bond, the value of the bond would have dropped 25% to $751.14. The obvious answer is to avoid interest rate risk by only investing in short term bonds; however, in normal functioning credit markets, the yield curve is upward sloping, meaning the yields on shorter term bonds are lower than those of long term bonds. In today’s low interest rate environment, the yield on one year Treasuries is only 0.13%i, well short of the rate required to fund a retirement and grow savings for the vast majority of the investing public.
The low interest rate environment also magnifies the inflation risk that investors bear when owning traditional Treasury bonds. Unlike equity securities, an investor that holds traditional Treasury bonds to maturity knows from the instant of purchase the nominal dollars that will be paid out because the promised payments do not change. While the nominal dollars received from bonds do not change, the purchasing power of those dollars tends to decline over time with inflation. The average year over year increase in the Consumer Price Indexa (“CPI”) has been 1.5% for the first ten months of 2013[iv]. If inflation as measured by the CPI is going to rise by 1.5% per year, then an investor must earn a nominal, after-tax return of 1.5% per year to simply maintain the purchasing power of one’s savings. One could maybe clear the 1.5% hurdle rate by investing in ten year Treasuries, depending on that investor’s tax bracket, but then the investor would be more exposed to the interest rate risk mentioned above.
So what is an investor to do? We believe that a larger allocation to equities is a great option, especially for those with long time horizons. However, violent drawdowns over short periods happen in the stock market, and there are many investors that cannot financially or psychologically sustain another sharp drop in equities due to age and reliance on savings. Performance of Treasury bonds historically have been uncorrelated to the performance of equities, and therefore provided a great tool for diversifying one’s portfolio. However, given the current low interest rate environment, interest rate risk and inflation risk may make Treasury bonds poor investments over the next several years. Investors could venture into the corporate or municipal bond markets and extract greater yields, but yields in those markets are also near historic lows and investors would be facing default risk as well as systemic credit risk that cause spreads to Treasuries to widen, in addition to the interest rate and inflation risks mentioned above.
The answer may be for investors to consider “Alternative” investment strategies. There are many different strategies that Alternative managers utilize to generate uncorrelated returns. Some use market neutral and/or other long/short strategies, others use arbitrage strategiesb, while others invest in special situation strategies such as distressed debtc. These strategies are increasingly being packaged into structures in which the general public can invest. Private transactions, whether in real estate or private equity, could also be a great Alternative investment strategy for those that have low liquidity needs relative to the amount of savings.
Sooner or later, the Federal Reserve’s aggressive intervention in debt markets will end and the historic low interest rates in the current market will climb. Investors that sought the perceived safety of the credit markets to escape the volatility of equity markets may be in for another painful surprise.
[i] Data provided by the Federal Reserve Bank of St. Louis as of December 5, 2013.
[ii] Data provided by the Federal Reserve Bank of St. Louis based on daily closing yields from 1/2/1962 to 12/5/2013.
[iii] The formula to calculate the value of a fixed coupon bond is as follows: (coupon / (annual interest rate / periods per annum)) - (coupon / (annual interest rate / periods per annum)) * (1 / (1 + annual interest rate / periods per annum) ^ number of periods) + (face value / (1+annual interest rate / periods per annum) ^ number of periods). In our example, the formula is ($14.50 / (4% / 2)) – ($14.50 / (4% / 2))*(1 / (1.04 / 2) ^ 20) + ($1,000 / (1.04 / 2) ^ 20) = $838.12.
[iv] Calculation based on CPI data from the Federal Reserve Bank of St. Louis as of December 5, 2013.
a Consumer Price Index ("CPI") - The U.S. Department of Labor defines the CPI as a measure of the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services.
b Arbitrage Strategies - Arbitrage strategies seek to profit from exploiting price differences of identical or similar financial instruments, on different markets or in different forms.
c Distressed Debt - Distressed debt is a debt security with low junk status and a market price substantially below par issued by a company with questionable ability to meet debt covenants and make timely payments. Distressed Debt funds aim to profit by purchasing debt securities from companies that the fund managers believe will ultimately be restructured or liquidated, enabling the company to repay the debt in part or in full at a profit to distressed investors.