On March 18, 2015, the Federal Open Market Committee (FOMC) completed one of its final prerequisites for making its first upward change in monetary policy in almost nine years. While economists generally agreed that the word “patience” would be dropped from the statement, interest rate futures markets have continued to be unimpressed. While many economists have stuck to their calls for a mid-June liftoff, markets are currently pricing in the first rate hike in September.1 With market prices and analyst views diverging, we believe investors should consider hedging their bets until the Federal Reserve (Fed) makes its first move.
Lessons from the Currency Market
In our view, the most relevant explanation for why an investor should hedge in front of a shift in central bank policy can be taken from lessons learned in the currency market since the announcement of European quantitative easing (QE). Making the wrong call on the euro has resulted in a loss of nearly 8%.2 While European equities have actually rallied by over 9% in local terms, U.S.-based investors who did not hedge currency risk are up less than 2%.
In the bond market, risks remain significantly skewed against lower yields. In our view, the case for lower yields amounts to a bet on deflation and Fed policy makers stuck in neutral. In the current market environment, U.S. Treasury bonds are trading more like growth stocks: Total returns are almost exclusively being driven by price returns. In our view, there will come a point when consensus shifts and bond prices correct lower. In fact, markets are already beginning to move in front of a shift in Fed action at the short end of the yield curve. The primary factor that makes the coming period of rising interest rates so problematic, and drastically different than in the past, is that coupon rates are so low. When rates begin to rise, there typically is very little cushion (via coupon payments) to help dampen losses.
What’s the Cost to Hedge My Bond Portfolio?
One of the primary struggles for most fixed income investors has been the issue of timing. Given that time is money (at least outside of Europe), hedging too early can cost investors performance relative to an unhedged position. However, on an annualized basis, the cost of hedging the interest rate risk of the Barclays U.S. Aggregate Index (Agg) is approximately 139 basis points (bp).3 Therefore, interest rates must rise by approximately 25 bp in order to break even on this position.4 While rates are basically flat compared to the start of the year, rates have already risen by almost 30 bp from their lows in January. This has resulted in total returns of approximately -1.22% for the Agg.5 Over this same period, a zero duration approach to the Agg returned +0.39% 6 . Again, with the margin of error so low, we continue to believe hedging is the most prudent course of action.
Bond Total Returns Driven by Interest Rate Risk
For definitions of indexes in the chart, please visit our glossary.
Hedging a New Position vs. Hedging a Portfolio
In the above example, we described the trade-off between an unhedged position in the Barclays Agg and a zero duration approach of the same Index. However, many investors have shown an unwillingness to sell out of legacy bond positions due to potential tax considerations, despite their view on rates. For these investors, another option would be to combine negative duration bond strategies to dial down the overall portfolio sensitivity to changes in rates. As we highlighted in the chart above, a negative duration approach7 combined with legacy positions could have helped offset losses experienced by the most recent move higher in rates.