Your Real Interest Rate Risks (And How To Manage Them)

Back in Time

It is the fear of rising rates which plagues investors and advisors alike and with good reason. However, the “good reason” to which I refer is probably different than those among investors and advisors. For most investors and advisors, the main fear is that rising interest rates will result in significant price declines among their fixed income holdings. However, falling bond prices are merely the symptom of an even greater problem. The greatest damage rising long-term rates can do to portfolios, which carry a large amount of duration risk, is that one’s income stream may not keep up with inflation.

Long-term rates move with inflation (not growth as the asset management folks preach). This can be proved by looking back in time.

10-year U.S. Treasury yields since 1962 (Bloomberg):

U.S. Inflation, as measured by Headline Annual CPI since 1962 (Bloomberg):

Annual U.S. GDP QoQ since 1962 (Bloomberg):

For the most part, GDP growth, inflation and long-term interest rates (10-year UST yields) moved together. This was because economic growth usually drives inflation higher which, in turn, drives long-term interest rates higher. However, this correlation broke down in the 1970s and early 1980s when inflation surged due mainly to higher energy prices, poor fiscal policy and monetary policy which (attempted) to foster economic growth through accommodation. The result was economic contraction, a weaker U.S. dollar and soaring inflation. This was the era of stagflation.

If long-term interest rates were track growth, the 10-year UST yield should have plunged in mid-1970s, late-1970s and the early 1980s. Instead, long-term interest rates followed inflation higher. This is because investors wish to be compensated for the erosion of purchasing power, caused high inflation, in the form of higher bond yields/income streams. I have yet to hear of an investor who wished to be compensated for the negative effects of higher rates of growth.

Investors who purchased the 10-year UST note in 1975 were in a bad way by 1980. Their income, which was generated from a yield of nearly 8.00% when purchased, lagged far behind the pace prices were rising in the U.S., at that time. It was this income underperformance which was most damaging to income investors, not the drop in the price of the 10-year UST note. In 1985, investors who purchased 10-year UST notes in 1975 received par. There was no loss of principal but there was a heck of a loss of purchasing power for a number of years. Even an investor who purchased 10-year UST notes in 1971 at 6.00% would not have lost principal, if he or she held to maturity in 1981, in spite of the sharp rise in interest rates over that time. However, as with the 1975 investor, his or her purchasing power was absolutely decimated.

There are ways in which investors can protect themselves from the effects of inflation. A popular method in recent years is to purchase Treasury Inflation-protected Securities (TIPS). These are U.S. Treasury securities indexed to the year-over-year change of the US CPI Urban Consumers Non-seasonally-adjusted Index (CPURNSA). However, this is not a fool-proof way of hedging inflation. This has to do with how TIPS are priced. TIPS are priced versus the yield of the corresponding UST note or government bond. This is the so-called TIPS breakeven that is much discussed in fixed income circles. How does this work? Let’s use today’s 10-year UST Note and 10-year TIPS as an example.

At the time of this writing. The yield of the 10-year UST note stood at 1.56%. The yield of the current 10-year TIPS stood at .007%. The difference between the two is known as the 10-year TIPS breakeven. The breakeven is supposed to (in an efficient market) accurately express the markets inflation sentiment for a number of years which correspond with the maturity of the TIPS and UST in question. The current 10-year TIPS/UST breakeven is 1.553%. Thus, if headline CPI averages 1.553%, there is no advantage to owning the 10-year TIPS over the 10-year UST note or vice versa. However, we do not live in a perfect world. If the U.S. economy reverted to 1970s like conditions, owning TIPS would be akin to hitting a home run. However, if the U.S. economy is battered by disinflationary headwinds from demographics, technology and globalization a TIPS breakeven of 1.553% might not be as attractive as it appears from an historical perspective. In my opinion, TIPS can make for a good inflation hedge, but it should be just one piece in a diversified portfolio.

Investors and advisors have been taught that fixed income portfolios should include protection from the negative effects of inflation and rising interest rates. For decades, inflation was the main fear in the fixed income markets. In a recent CNBC interview, Columbia University professor and former Fed governor, Frederic Mishkin, stated that he spent his 40 years as an economist focused on rising inflation and how to contain it. However in recent years, concerns over disinflation and deflation have increased. If a disinflationary scenario materializes (continues), owning TIPS or focusing on the short end of the curve could result in sub-par performance in terms of income generation, in both nominal and real terms. This is where maturity diversification can help.

Portfolio maturity diversification involves not having most or all one’s fixed income investment capital on one area of the yield (or credit) curve. The two most popular maturity diversification strategies are the bond ladder and the bond barbell. (5) (6) (7)

Climb the Ladder

A bond ladder is, in a way, an interest rate/inflation hedge strategy. By having exposure across a wide spectrum of the yield curve, the portfolio offers some protection against rising rates (inflation) and persistently-low rates (disinflation). If interest rates rise over time, bonds on the short end of the ladder allow investors to reinvest matured principal at higher rates. However, if interest rates do not rise much, are little-changed or fall, longer maturities in the portfolio can provide attractive income streams, on a relative basis. A bond ladder can also provide investors with a fairly predictable income stream. Knowing what ones income stream is very important to retirees who rely on investment income to fund lifestyles (expenditures).

A bond ladder can also provide investors with predictable return of principal. Rather than worry about what a portfolio might be worth at a given time. A ladder of bonds provides a predictable schedule of when investment principal will become available, if it is needed by the investor. An investor who wishes to take a much desired trip in three years can(depending on the credit quality of the bond) count on the principal invested on the three-year area of the curve being there to fund the trip. This alleviates the worry of where interest rates are and what bonds might be worth in the open market at that time. (5) (6) (7)

A Barbell for Heavy Lifting

Where regularly-scheduled maturities are not needed, but where protection from various interest rate and inflation conditions are desired, a barbell strategy might be appropriate.

A barbell is simple a portfolio which has investment capital focused on the long and short ends of the yield curve, with few or no holdings on the intermediate portion of the yield curve. This allows investors to generate a fair amount of income (via long-dated holdings), but have a measure of reinvestment flexibility from holdings on the short end of the yield curve. This is a more aggressive hedging strategy as it does not permit investors to count on a steady return of principal. However, in a rising interest rate environment, a barbell is often a more advantageous strategy than a ladder.

In a typical rising rate/Fed Tightening scenario, a barbell tends to be a very good strategy. The short end of the barbell allows investors to roll up with rising policy rates while the long end of the barbell continues to provide relatively-high income. Since the yield curve tends to flatten when the Fed tightens, the long end often provides a steady anchor at some point during the tightening cycle. However when the curve steepens during an easing cycle, long-term rates tend to rise as the bond market begins to price-in hotter inflation resulting from accommodative monetary policy. In this scenario a ladder or a bullet (bullet-like) like strategy may be most appropriate for fixed income investors. (5) (6) (7)

When the Bullet Hits the Bone

In a bullet strategy, investment capital is focused on the intermediate portion of the curve. Holdings on the long and short ends of the yield curve are minimal. A bullet strategy is often implemented when an investor needs principal to mature to meet a specific liability. An investor whose goal is have money available to fund college education, might focus bond holdings on the point of the yield curve which corresponds with the timing of that expense. Smaller amounts of capital would reside on the short end of the yield curve (to provide flexibility in case interest rates rise) and on the long end of the curve (for the purpose of generating a higher yield than what can be had on the focused portion of the yield curve). A bullet can also offer some stability when the economy, monetary policy and the yield curve are in states of transition. Most of the volatility occurs on the extreme ends of the yield curve (price volatility on the long end of the yield curve and yield volatility on the short end of the yield curve). (5) (6) (7)

The Best is yet to be Determined

We have discussed the three basic bond portfolio strategies. Which one is the best? None of them are the best. In fact, none of them might be appropriate for some clients. Individual clients have individual needs. Some investors desire high current income and might focus on the long end of the yield curve, regardless of interest rate expectations. Other investors prefer or need to remain liquid. They might focus investment capital on the short end of the yield curve, even when short-term interest rates are low and are expected to remain so. Some investors will target specific years, even specific months within those years, to fund anticipated needs. This is akin to an actuarial strategy that an insurance company or pension fund might use.

There is no right portfolio. However, investors and advisors need to have, at least, a working knowledge of these portfolios, not only to construct client-appropriate portfolios, but to make certain that third-party bond portfolio managers are acting in the client’s best interest. The old men’s clothing retailer, Syms, had a slogan of: “An educated consumer is our best customer.” I subscribe to the same thesis. I maintain open lines of communication with investors and advisors. (5) (6) (7)