September 2014

BONDS: The great rates riddle

New YorkThe markets seem to be underpricing the Fed's inevitable interest rate rise. Can managers reduce the duration of their portfolios without sacrificing yield? George Mitton reports.

The last time the US Federal Reserve raised interest rates by a significant margin was in 2004-05, when rates rose 4.25 percentage points in two years. This was more than the average investor, polled in 2003, had predicted, says Cosimo Marasciulo at Pioneer Investments, who recalls the poll.

What’s startling is that today, market expectations for a rate hike are less than the underestimates of 2003. The market guessed too low then, and it’s guessing even lower this time.

Marasciulo, head of government bonds, who has analysed the previous rate cycle, says investors have failed to learn lessons.

Although the market is correct, in his view, to anticipate the beginning of the rate cycle some time in 2015, he thinks market expectations of a terminal rate of about 2.5% are off the mark.

“We think the market is way too complacent,” he says. “We think the Fed will go for a proper tightening cycle, 3.5-4% could happen, but the market isn’t ready for it.”

Why is the market expecting such a small rise in rates when the evidence of the last cycle suggests a much larger one? One reason was poor GDP data for the first quarter, which caused a lot of investors to lower their growth forecasts for the US economy. Together with the slow and bumpy recovery since the financial crisis, this evidence prompted some investors to claim the US is not in a normal cycle but is stagnating. 

In such an environment, they say, the Fed cannot afford to raise rates as much as it would do in a true recovery. However, Marasciulo believes interest rate expectations are too low, even in this pessimistic scenario.

“At current levels you are more than pricing in stagnation,” he says. “A 2.5% terminal rate is lower than the Fed anticipates.”

On top of this, recent economic data from the US has been encouraging. If, as a number of commentators have said, the poor first-quarter data was a blip, influenced by unusually bad weather in the US, then the US economy is in better shape than previously thought. Providing the risk of deflation stays low, the Fed will be able to tighten to more than 2.5%.

The solution for funds that Marasciulo manages is to reduce the duration of bond portfolios so they are less sensitive to a rise in rates.

Of course, reducing the duration of bond portfolios is not a new idea. This has been one of the main themes in fixed income investing in recent years. The bond mathematics is fairly straightforward: the value of a short-maturity bond will fall less if rates rise than the value of a long-maturity one.

But there are sacrifices to be made when moving short. Take two-year US treasuries, for instance, which currently offer a yield of about 55 basis points. A five-year treasury, in contrast, has a yield of about 1.75%.

“If you pull back into shorter maturities you’re giving up a certain amount of yield,” says Simon Hawkins, fixed income portfolio manager at Conning, an asset manager for a number of insurance companies.

In addition, moving to short duration means giving up on the potential gains offered by roll return, the phenomenon in which, assuming the yield curve is relatively steep, a bond becomes more valuable the nearer it gets to maturity. The classic way to profit from this strategy is to buy long-dated bonds and sell them after two or three years to make a profit.

“That roll-down is quite powerful and in short durations you lose that,” says Hawkins.

Like Marasciulo, Hawkins anticipates a rate hike from the Fed in 2015 and says it does make sense to shorten duration to prepare for that. The yield on two-year treasuries, for instance, “looks on the low side” given his expectation of Fed action. But he thinks it is a mistake to move aggressively short – the sacrifices in terms of yield and roll return are considerable.

He adds, though, that much is still uncertain. In effect, the current yield curve implied for a year’s time reflects a middle position that few people expect to materialise. If the US economy recovers, the Fed will raise rates higher than the curve implies. If the economy stagnates, rates will have to stay low. Most people view the situation as an either-or.

What, then, can fixed income investors do to maintain returns as they shorten the duration of their bond portfolios? If mandates are flexible, fund managers can offset the performance deficit by taking unorthodox positions, for instance using options to gain exposure to volatility.

Another alternative is to diversify portfolios by investing in corporate as well as government bonds – especially high yield bonds. However, even here, investors do not escape interest rate risk. One of the features of the post-financial crisis world is that corporate bond investors, including investors in high yield bonds, have to worry about rate risk too. For high yield bond investors, this is novel. The situation has come about because of historically low interest rates and because yields of high yield bonds are, well, not so high any more. 

In this environment, high yield bonds are much more sensitive to interest rates than before. As you’d expect, this has pushed up the price of short-dated high yield bonds.

“Your payment for taking risk is poor at the front end of the curve,” says Fraser Lundie, co-head, Hermes Credit. “But clearly no one wants to touch the long end because they’re worried about rate rises.”

Lundie says the solution is to take unconventional exposure to the long-end of the yield curve – without taking on interest rate risk. One method is to sell credit default swaps (CDS) against target companies. A CDS is essentially the mirror of a bond. Selling a CDS contract means receiving the same income a bond would pay. The difference is the value of the contract is not determined by interest rates – it is simply a bet that the target company won’t default.

Another option is to buy a long-dated high yield bond but simultaneously take a short position on government bond futures. The short position will ensure you are compensated if rates rise and the value of your bond falls.

Lundie says these unorthodox techniques have allowed him to keep his exposure to interest rate risk low while gaining the extra yield offered by long-maturity bonds.

“Within our high-yield strategy, our duration is significantly lower than the market’s, but we’re involved in securities that are longer than the benchmark.”

Lundie says his fund is at an advantage because it was established in 2010, after the financial crisis. 

Its makers were able to include CDS and various derivatives in the fund’s toolbox, whereas many high yield bond funds set up before the crisis are not allowed to invest in these kinds of instruments. Managers of inflexible mandates have few tools at their disposal to counter interest rate risk, apart from trying to hedge their bets by taking on more credit risk.

Unorthodox techniques come with their own pitfalls, though. The use of derivatives entails counterparty risk. Some investors may not be comfortable with fund managers buying exotic instruments such as CDS. Perhaps, though, it is worth living with these drawbacks to avoid compromising on yield while waiting for that long-awaited hike in interest rates.

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