In our Weekly Market Update we have made an effort to track the deflationary story being told in the global fixed income markets, specifically sovereign yields have continued to trade lower defying what most investors thought was possible; Swiss 10 year debt recently yielded 25 basis points. A while back I quoted a Seth Klarman Tweet about German debt trading at multi-century low yields.
Many thought that the 30-plus year bull market ended in June of 2013 when the Fed first talked about tapering its asset purchases (the Fed never actually used the word tapering in its statements) which caused a pretty violent, albeit short-lived, panic in the bond market. Arguably the bull market has continued through today with no idea of how long it can last.
Although there is folly in trying to predict when rates across the bond market will actually rise (the Fed only controls a couple overnight rates; the Fed Funds Rate and the Discount Rate), with the Fed’s telegraphed intention to start raising rates by the middle of next year it becomes prudent for market participants (both advisors and do-it-yourselfers) to game plan a rising rate environment. The sense of panic that occurred in June 2013 should make the need for this clear. Emotions can trigger from both equity and fixed income market volatility and of course periods of heightened emotions are when investors are more likely to make poor decisions.
As a reminder there is a general rule of thumb that a ten year bond will drop 8% in price for every 1% increase in interest rates. Yes, an investor will likely get their principal back at maturity but if they wait until maturity they are collecting a below market yield until the issue finally does mature.
Certainly shortening maturities will avoid most of the brunt of a big lift in rates but an entire fixed income portfolio that only yields 80 basis points will be difficult for clients both in terms of their patience and keeping their financial plans on track.
In terms of solutions there are of course several different paths to take. Coincidentally, the Barron’s cover story this week looks at Best Income Ideas For 2015. While it is a good article it is kind of a strategy free list of various income segments some of which can be very volatile including dividend stocks which as we’ve said before; dividend stocks are stocks not bonds and their volatility characteristics are not like bonds. They may be low vol for equities but that is not the same as fixed income.
Over the years of this blog I’ve written about two specific solutions for a fixed income portfolio. Specifically I’ve been a believer of owning small slices of various fixed income segments including foreign, preferred stocks, mortgage, inflation protected and several others while avoiding the most overpriced segment which I believe is US treasuries. Treasuries have been expensive for a long time, have continued to get more expensive and could continue to go up in price but buying high is still buying high and that is usually a bad idea. To the extent you are interested in a fund that would do this for you, the terms that has come into play here are multi-sector and unconstrained. Obviously there are plenty of funds within each individual segment to explore.
One segment that has attracted assets in the last few years are floating rate loan fund. The basics are simple; the loans tend to be lower rated or unrated with appeal being that the rates adjust with the market, usually every three months. So as prevailing rates go up then rates charged to borrowers (loans made by the fund) also go up. While there is still credit risk, interest rate risk should be off the table and of course we are focusing on in this post is interest rate risk.
I think there will be a lot of product development in the realm of strategies to help deal with rising rates. Recently I have started to learn more about negative duration. There are already several ETFs in the market place that strategically create a negative or zero duration. In a normal bond portfolio you have some duration which is similar to maturity although duration is a more accurate measure of the average length of your bond portfolio.
The biggest bond funds all have positive durations and the number is easily found on the info page for a given fund. You might see a duration of five point something years on a fund tracking the Aggregate Index but whatever the number, if positive, it will take on some amount of interest rate risk. Low and negative duration funds are likely to grow in popularity because there will be increased need at some point for increased bond portfolio protection.
It is important to realize that the planet will not stop rotating on its axis if ten year yields trade in line with the historical average of 6% (per Barron’s) but the path to 6% will be very painful for a lot of bond portfolios.
This article was written by AdvisorShares ETF Strategist Roger Nusbaum.