Return-Free Risk

THE LONG-TERM BOND MARKET

Government bonds represent one of the oldest forms of financial securities. In the 17th century, England issued government bonds in order to finance Her wars. For its part, the United States almost immediately became indebted, issuing credit in order to support the Revolution and establish its nascent union. Over the centuries, the sovereign bond market has become a staple of the financial world, and since conclusion of the Second World War, the United States Treasury market has served as the standard for all debt markets. The US Treasury has become such a staple many domestic investors have adopted the instruments as “risk-free return,” that is, the amount an investor can earn without taking risk. Yet a strong bond market over the last few decades, with bond yields at record lows, and the United States fiscal strength deteriorating, has recently made investors question that assumption. Today it may be whether investors are receiving a “return-free risk” instead.

There is an absolute truism in debt markets: if the yield (the rate paid for borrowing money) on a bond rises, the price of that bond falls, and vice versa. The relationship between yield and price is not hypothetical but rather mathematical called duration. Simply put, if a bond has a duration of 10, anytime interest rates moved up 1%, the bond would go down in price 10%. This serves as the reason that bond markets are quoted in yields rather than price. With that in mind, we examine a 50-year chart of 10-year US Treasury Bond yields.

Source: Bloomberg Professional

The chart clearly displays that since the early 1980s and the Volker-led Federal Reserve, yields on US Treasury notes have steadily fallen indicating a strong bond market performance. Today, yields on the 10-year Treasury note sit near historic lows as investors have continued to purchase the securities for the perceived safety. The bonds do not reveal the same safety if viewed on the left side of the previous graph.

Both the world and domestic bond markets have changed dramatically from the days before the financial crisis of 2008. Many have begun to wonder aloud how much longer investors will loan money to the US Treasury for 2% annually, especially after the unprecedented amounts of both fiscal and monetary stimulus of the past years coupled with the $15 trillion of accumulated debt.

Inflation is a primary concern for debt investors, and if it begins to be recognized in the domestic economy, US Treasury holders could begin to demand more compensation and sell current holdings. The rise in yields would reverse the bullish trend over the past 30-years, however, a dramatic rise in rates would not be without a historical example (see: 1970s). The impact of rising rates for US bond investors could be amplified because the yields are so low, leaving many to question the true risk they are taking. While bond yields may theoretically go extremely high (as exemplified most recently by Greece), they have, again in theory, a finite level to which they could fall: zero. It would be an almost unfathomable situation in which an investor would pay the government to loan it money for several years (thereby driving yields into negative territory). However, short time frames may be different. In the heart of the financial crisis in 2008, short-term Treasury bills (securities with less than a year to maturity at issuance) actually briefly printed a negative yield.

The term “return-free risk” for US Treasuries was coined by famed investor James Grant, editor of Grant’s Interest Rate Observer, in late 2008. In an article publish in the Financial Times that year, Grant emphasized an old traders’ maxim: “There are no bad bonds, only bad prices.” In other words, Grant believed that US Treasuries were too expensive and posed a poor risk/return proposition for investors (note: according to Bloomberg, the day Grant’s insight was published, December 4, 2008, the US generic 10-year yield closed at 2.55%. As of the time of this writing, April 12, 2012, the 10-year yield closed at 2.05%. In short, it’s more expensive now than it was then).

Source: Leuthold Group, Tradewinds

Numerous others have also examined the asymmetric return profile associated with longer-term Treasury bonds. In January, the Leuthold Group created an illuminating chart of a hypothetical 20-year Treasury Bond in comparison to the S&P 500. Dave Iben, who recently departed from Tradewinds, showed the chart in his quarterly letter. The results highlight the risk with longer-term US bonds. In short, if rates rise rapidly over the next few years, the long-term Treasury bond would suffer due to its duration risk. While the Leuthold bond is a hypothetical example, it illustrates an important point: long-term Treasury bonds have limited upside, with potentially a large downside. The last two columns of this table show what would have to happen to the stock market in order to have the same effect as rising interest rates have on bonds.

THE FED’S PLEDGE

Recent domestic economic data in the United States has continued improving. Unemployment, manufacturing, consumer confidence and corporate earnings have had positive data recently. Trailing twelve month domestic earnings, as measured by the S&P 500, reached an all-time high at the end of the first quarter 2012 of over $96 of earnings per share and Bloomberg consensuses estimates call for the trend to continue. Even on a real basis (inflation-adjusted) earnings are expected to reach all-time highs as soon as the second quarter 2012. Yet, even with all the solid news on the economic front the Federal Reserve remains dovish. In their most recent meeting in March, the Federal Open Market Committee (FOMC) reiterated that it anticipates “economic conditions…are likely to warrant exceptionally low levels for the federal funds rate at least through late 2014.” Even with a gradually improving economy, the Federal Reserve pledged to keep its benchmark interest rate near zero for at least two and half more years. The ramifications of such unprecedented monetary policy could have a profound impact on global markets.

Source: Bloomberg Professional

Perhaps the largest concern with such accommodative monetary policy involves its inflationary tendencies. Since the financial crisis of 2008, the Federal Reserve has actively been trying to “reflate” the US economy by injecting massive amount of funds into the money supply. The Fed Chairman, Ben Bernanke, spent a great deal of his academic career studying the Great Depression and the detrimental effects of a deflationary spiral. He has repeatedly referenced the need to avoid such a market environment, even going as far to say the Fed should drop money from the sky during his famous (infamous?) “helicopter” speech in 2002. The explosion of central bank balance sheets to combat deflation is hardly just a domestic issue (see graph), but we will focus on the US aspect most closely. While the US economy remains below its potential output, the recent gains in economic activity concern some that the Federal Reserve may not remove at least some a portion of its stimulus policies before inflation becomes problematic. Inflation, as we know from before, is bad for bond investors, and those investors with longer duration fixed income holdings (like long-term US Treasuries) could be taking on more risk than they realize.

Source: Bianco Research, The Big Picture (ritholtz.com)

There is, of course, a counter argument to the idea that domestic monetary policy could have an inflationary outcome. The contrary side contends that the ultra-low interest rates may have slipped the United States into what Keynes referred to as a “liquidity trap.” In short, such a scenario renders monetary policy ineffective and rates remain exceptionally low. This scenario is not unprecedented: Japan has been suffering from a trap over the past twenty years. Paul McCulley, a former PIMCO portfolio manager, has already declared the United States is in a liquidity trap. James Bullard of the Federal Reserve Bank of St. Louis published a paper in 2010 called “Seven Faces of ‘The Peril’” in which he examined the possibility that the US enters a Japanese-style deflationary environment. Bullard claimed the extended low nominal interest rate environment makes the US “susceptible to negative shocks” (such as a disorderly default of a European government) which could keep interest rates low indefinitely. In other words, the Fed does not have enough “dry powder” to stimulate the economy should another crisis emerge. He concluded by stating the “U.S. is closer to a Japanese-style outcome today than at any time in recent history”.

While both scenarios above – rapidly accelerating inflation and a deflationary spiral – remain tail risks at this point (a much more plausible expectation would involve the US economy “muddling through” and slowly improving) both would have very different effects on the US Treasury market. On one hand, the inflationary scenario could have a devastating outcome for holders of long-duration bonds. Conversely, in a deflationary environment, US Treasury holder could presumably realize modest returns. A third scenario called “Stagflation” was experienced in the 1970s in which the economy stagnated while inflation rose. Again, with the US 10-year Note yielding around 2% and the uncertainty in the current market, it appears the securities have an asymmetric risk/return profile.

THE SEARCH FOR YIELD

The low interest rate environment has presented a conundrum for investors needing current income. Where can investors find yield? In the years since Jim Grant first introduced the term “return-free risk,” a few alternatives to traditional domestic government bonds have emerged. First, investors can decrease the quality of traditional fixed income or increase the duration of credit holdings. Next, they could diversify their fixed income allocation geographically. Finally, investors could look for yield in other asset classes such as master limited partnerships or dividend paying equities.

The first method investors have attempted to increase yield involves relaxing credit quality standards of a portfolio. For example, a BBB rated corporate bond with 15-years to maturity has higher yield compared to a 10-year Treasury Note. While the yield may be greater, the risk with lower credit issues also increase. An industrial company, in theory, has more of a chance for default (i.e. not making full principal and interest payments) than a US Treasury.

Another technique for increasing interest is by lengthening maturity. By increasing maturity you increase the duration of bond holdings which actually increases a portfolio risk should interest rates rise in the inflationary scenario. A potential solution to reducing interest rate risk would be investment in floating-rate bonds. These bonds have much lower duration risk because the payments or principal move in correlation to interest rates. Yet, the largest issues of these bonds are of intermediate and lower credit quality.

Next, investors may diversify their portfolios geographically by buying credit of governments throughout the world. One can generally increase yields by investing in countries that are growing at different rates. However, by allocating part of a portfolio to international fixed income investors also take on new risks such as sovereign risk (think Greece) and currency risk. Additionally, international fixed income may present a different risk return profile than traditional domestic fixed income.

Perhaps the most discussed solution in the media has been the introduction of altogether new asset classes to increase a portfolio’s yield. Both master limited partnerships (MLPs) and real estate investment trusts (REITs) must distribute a large portion of earnings as income to their investors making their yields higher than some bonds. Both of these asset classes, however, have experienced high volatility in recent years so their suitability to replace fixed income may not be appropriate.

High-quality dividend paying equities have recently emerged as popular solution for generating yield. In fact, according to Bloomberg estimates, the S&P 500 expected dividend yield is comparable to the yield on the 10-year Treasury. Investing in companies that have higher consistent dividends and diversifying the portfolio internationally could increase yields on equities even more. Take the Dow Jones Select Dividend Index, for instance. The Index (orange) has had a higher expected dividend yield than the 10-year (light green) and most recently has almost twice the yield of the 10-Year Treasury.

Source: Bloomberg Professional

The overwhelming size of the OTC derivatives market does highlight the interconnectedness of modern financial markets. It also illustrates why certain institutions (Bank of America, American International Group (AIG) and Citigroup come to mind) may be considered “too big to fail” as a bankruptcy could cause a domino An important fact to remember about investing in dividend-oriented companies is that they ARE NOT BONDS. While dividend-paying equities may serve as an appropriate compliment to a stock portfolio, they may not be an appropriate for replacing a fixed income position. First, they have a great deal of volatility. In an April 12, 2012 article by Jason Zweig in The Wall Street Journal, “The Dangers of Dividend Funds,” he points out that, according to Morningstar, in the fourth quarter 2008 dividend-oriented mutual funds fell 20.2% while the S&P 500 as a whole lost 21.9%. While Zweig correctly notes over longer periods dividend oriented strategies have had less volatility than broad based equity markets, he also alludes to a far more important point. That idea is correlation and the benefits low correlated asset classes can have on a portfolio. In the final quarter of 2008, while equity markets underwent turmoil, Zweig notes the Barclays Capital US Treasury index gained 8.75%. In other words, historically, when equities “zig,” US Treasuries “zag” (or at least don’t “zig” as much). While dividend focused equity strategies may be appropriate in a portfolio, it is important to remember that they are significantly different from investing in bonds.

CONCLUSION – HIGH DIVERSIFICATION / LOW CORRELATION

The US Treasury market has experienced a strong bull market over the past three decades. The financial crisis of 2008 has driven may maturities in the market to record low yields as investors clamored for perceived safe haven in US government bonds. The record low yields present investors with an asymmetric risk/return profile; that is, investors face potentially large downside to their investment while only modest upside.

Unprecedented monetary policy in both the US and around the world has complicated all markets and could have a huge influence on the Treasury markets in the future. Finally, investors have attempted to find income in various asset classes but each present the investors with new risks.

Diversification can add safety to a portfolio, especially when diversifying between assets with low correlation. The effect of correlation on an investment portfolio is the secret to true diversification. The end result is that the whole portfolio, diversified with low correlation assets, can become safer than the sum of its parts. By blending together portfolios with the different asset classes mentioned in this report, investors may be able to protect capital, and enjoy a higher yield than a non-diversified, all bond portfolio.

Finally, a as bit of Lagniappe (and admittedly a bit off subject) Morgan Housel of the financial website “The Motley Fool” put together a list of 50 amazing numbers from the economy. We thought we would share a few of them that we found interesting.

A record $6 billion will be spent on the 2012 elections, according to the Center for Responsive Politics. Adjusted for inflation, that’s 60% more than the 2000 elections.
In 2010, nearly half of Americans lived in a household that received direct government benefits. That’s up from 37.7% in 1998.
As the market was “flat” from 2000 to 2010, S&P 500 companies paid out more than $2 trillion in dividends.
According to Goldman Sachs’ Jim O’Neill, China’s growth creates the equivalent of a new Greece every 90 days
Americans age 60 and older owe $36 billion in student loans.
Just five companies, Apple, Microsoft, Cisco, Google, and Pfizer, now hold nearly one‐quarter of all corporate cash, equal to more than a quarter‐trillion dollars.
Total government employment has shrunk by almost 700,000 since 2009.
For the first time since 1949, the U.S. is now a net exporter of fuel products like gasoline and diesel.
The period from March 2009 to March 2012 was one of the strongest three‐year market rallies in history ‐‐stronger, in fact, than the 1996‐1999 bull market.
Adjusted for inflation, the bursting of the housing bubble destroyed wealth equal to half a 1950s America.
As the economy tanked in 2009, the top 25 hedge fund managers collectively earned $25.3 billion. On average, that works out to about $2,000 a minute for each manager.
Household debt payments as a percent of income are now the lowest since 1994.

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