This article was written by the Institutional & Insurance Investments group at Brown Brothers Harriman. For more articles, please visit the Institutional Asset Management site or the Insurance Asset Management site.

May 27, 2003

Down for the Duration

Andrew P. Hofer

This overview describes current interest rate levels in historical context, and describes how the potential for negative returns has increased for fixed income investors. It concludes by listing some techniques by which portfolio managers may mitigate the risk presented by potential rate increases. Short articles describing each of these risk management techniques will appear on this site over the coming weeks.

UPDATE: Here are the articles:

  1. Going Short — Is it the Time to Take the Chips Off the Table?
  2. Barbelling the Portfolio: One Way to Reduce the Risk of Rising Interest Rates
  3. Low Rates (on Their Way Higher?) and Inflation – Indexed Bonds
  4. Buying Spread Duration and/or Hedging Treasury Duration to Reduce the Risk of Rising Interest Rates

History is truly made every second. As Treasury yields have screamed past 30-, 40-, and 45-year lows over the last year, we have had little opportunity to stop and take in the view. Thanks to the attendant capital gains, bond investors have been able to enjoy above-coupon returns on their bond investments and absorb some of the pain doled out by the stock market. Yet, there is “growing unease”, as pundits like to intone ominously, about future returns in the bond markets.

It is far from clear whether GDP growth will soon return to stronger levels, and recent economic signals have been mixed. Employment is still very weak. Confidence and consumer spending have also been slow, although sentiment measures ticked up substantially in the wake of the war in Iraq. Corporate earnings are also making a surprisingly strong showing in Q1 2003. Our own forecast leans toward a mild recovery.

There is still a possibility of another Fed rate cut on June 24–25, but rates are now so low that even in a relatively stable rate environment high quality bonds offer both negative real returns and low nominal returns for the potential interest rate risk.

Investors rarely, if ever, accept negative real yield on an ex-ante basis, but that is the case today in the context of extraordinarily high levels of risk aversion. Graph 1 describes the history of the “real” yield of the five-year Treasury Note (“real” yield defined as the yield-to-maturity at the market price less trailing 12-months CPI). While nominal interest rates had declined, by 2001, to levels unseen in a generation, the negative real interest rate environment developed only in the last six months. Five-year real Treasury yields were last negative in 1974–1976 and 1979–1981, as a result of unanticipated inflation.

The only ways that five-year Treasury Notes can yield a positive real return, therefore, are if nominal rates continue to decline or inflation turns out to be significantly less than recent measurements of about 2%, which is close to both the long-term average and our own longer-term predictions of 2.5%.

A positive real return prognosis for Treasuries, therefore, depends on a disinflationary outlook that we do not consider likely over the longer term.

What is the downside risk?

Having established above that real returns on bonds can be negative with no change in rates, what about the possibility for negative nominal returns?

Fixed income investors tend to have asymmetrical risk tolerance — they are tolerant of variable positive returns, but intolerant of returns less than zero, often because negative returns find their way into an income statement as a loss. It is important to note that a very low interest rate environment brings the bond investor much closer to the negative nominal return threshold.

Graph 2 depicts the amount by which interest rates would have to rise for two-year and five-year Treasury Notes to produce a nominal return of zero over a given period.1 Any greater increase will produce a loss. We call this the “Zero-Return Rate Rise”.

For instance, the last point on the lower of the two lines in Graph 2 shows that the five-year Note can deliver a negative return, over a year, with an increase of 117 basis points or more in rates. We present the history of this Zero-Return Rate Rise for the five-year Note over one-year holding periods in Graph 3. This measure (which, again, relates to nominal rates, not real rates) is at historically low levels.

Graph 4 depicts the Zero-Return Rate Rise for various levels of credit quality. As you can see, investing in diversified credit exposure provides substantial protection against negative returns. For instance, two-year AA corporates will yield positive returns unless interest rates increase by 210 basis points, as opposed to only about a 160 basis point increase for the equivalent U.S. Treasury. The advantage of credit spread is a theme to which we will return later in this article.

What is the market telling us?

Two measures suggest a market consensus, of sorts, on interest rates. The first is the current U.S. Treasury yield curve, which is steepest from two to five years. (See Graph 5).

Second is the price of interest rate futures shown in Graph 6. The top curve is the current market for futures contracts on three-month Eurodollar obligations, while the blue line is futures on the Fed funds rate (an overnight rate). 

The yield curve and futures pricing suggest that rates will decrease in the near future, but begin to rise in the autumn, with higher rates expected over the long-term.

We should note that forward rates are affected by a variety of technical factors and are not particularly good predictors of short-term interest rate movements.

The shape of rising rates

Investors need to keep in mind that nominal rates are made up of several components, each of which will vary in size at different maturities:

Inflation-indexed bonds, of course, remove the first two components and are, therefore, exposed only to real rate risk.

Several factors influence the demand for long bonds vs. short bonds:

  1. Compensation for interest rate risk (tends to steepen curve)
  2. The cumulative effect of inflation (tends to steepen curve)
  3. Expectations of inflation in future years (can influence curve either way)
  4. Expectations for real and reinvestment rates in future years (can influence curve either way)

These factors can only be disaggregated to a certain degree. Inflation-indexed securities, to which the future inflation expectations presumably do not apply, trade at 5-, 10- and 30-year yields that are 1.36%, 1.71% and 2.23% lower than conventional notes/bonds, respectively, (as of 5/19/03). This measure is known as the “breakeven inflation rate”. This suggests an inflation expectation only slightly lower than our own long-term assumption of 2.5%.

Given the massive amounts of stimulus in the economy right now from expansive fiscal and monetary policies, a strong upturn in employment and earnings would eventually prompt the Federal Reserve to withdraw monetary stimulus rapidly. This will cause real rates to rise across the yield curve, but most sharply at short maturities. As long as inflation remains under control, inflation-based rates will not rise, and the longer end of the maturity spectrum will see less dramatic rate increases overall. Finally, we observe that the highest-quality and shortest instruments have benefited from a “flight to quality” in the post-terrorism era, and certainly during the war. An economic recovery would reverse these risk premia (as has already happened to some extent in the high yield market) and again cause shorter rates to rise faster than long-term rates.

Thus, typical recovery scenarios would suggest a “flattening” rather than “steepening” yield curve with the bulk of the increase in rates falling in the short real rate component. In turn, this suggests two strategies: barbelled short portfolios and the use of inflation-indexed bonds, but only at longer maturities. We discuss both of these strategies below.

Special Concerns for Short-Intermediate Investors

We are particularly concerned about investors with portfolio durations around two years. First of all, in an environment where the Federal Reserve is tightening monetary policy, we would expect two-year rates to increase more than five-year rates. Secondly, many two-year investors have become accustomed to much higher returns than on cash and a history of almost no negative return quarters. In more technical terms, the two-year U.S. Treasury Note has offered a far superior Sharpe Ratio2 to maturities under 180 days and has, therefore, proven to be a logical choice for the “enhanced cash” investor. Over the past decades, we have pointed this out to many clients, and helped them capitalize on it profitably. We are concerned that the next few years will not match the past, and we are, therefore, recommending some protective measures. During most interest rate regimes, the two-year benchmark has been a very effective strategy, and it will be again, but we do not currently see compelling value in targeting a two-year maturity.

In addition, because of the steepness of the yield curve between two and five-years, two-year portfolios are out-yielded by barbelled portfolios of the same average duration (see “Barbell the Portfolio” below).

Mitigating the Risk of Rising Rates: Five Techniques

Below, we describe five different techniques to mitigate interest-rate risk in today’s environment. We have used a mix of these ideas, as tactically appropriate, in client portfolios throughout the last 12 months, and expect to continue to do so.

Shorten the Portfolio

The simplest way to decrease the risk of rising rates is to shorten aggregate portfolio duration. Unfortunately, in a market attuned to the possibility of higher rates, this is a costly strategy. The portion of the yield curve from two to eight years, where most bond portfolio investors tend to be concentrated, is extremely steep. Every step down that curve exacts a substantial cost to the portfolio’s running yield.

For those two-year investors who are guideline-restricted to high quality instruments, and who cannot book a negative return, we recommend targeting shorter duration. For more ambitious two-year investors we suggest a “LIBOR-Plus” approach, detailed below.

Tom McDonald offers more perspective on shortening duration.

Barbell the Portfolio

Graph 7 shows the potential relative return of a 58%/42% barbell of cash and five-year U.S. Treasury Notes against a two-year U.S. Treasury Note under various steepening and flattening scenarios. With no rate change (where the line crosses the vertical axis) you can see that the barbelled portfolio carries a running yield advantage of 32 basis points. The 2–5 year curve must steepen by 17 basis points (where the line crosses the horizontal axis) or more for the two-year U.S. Treasury note to outperform the barbelled portfolio.

A barbell makes sense at the shorter, steeper part of the curve. However, barbells are macro bets on interest rates and carry a lot of price volatility. Even if one’s interest-rate prognosis is correct, it can often be a bumpy ride. Witness, for instance, the rally in bonds during the week of May 6 when the Fed did not ease and a slow news day brought stories of potential deflation.

Mike Walsh describes the barbell technique in greater detail here .

Use Inflation-Indexed Bonds

Calculating the “duration”, or interest rate sensitivity, of inflation-indexed bonds has been a puzzle since they were first issued. This is because duration of nominal bonds is a derivative of price with respect to a change in nominal rates. As mentioned above, inflation-indexed bonds have only “real rate duration”, not nominal duration. So the only way to make an apples-to-apples comparison of durations is to take partial derivatives of price with respect to real rates (real duration) and inflation rates (inflation duration). The latter, for inflation-indexed bonds, is zero. Because of the lower coupons, however, an inflation-indexed bond has a greater “real duration” than a nominal Treasury of similar maturity. In a rising real-rate environment, therefore, TIIS will underperform nominal Treasuries (as they did in 1997). My colleague, Jerry Cubbin, addresses this issue in greater detail in an article published last October.

Given the possibility of higher real rates at the short-end of the curve, inflation-indexed bonds are most appropriately used to reduce inflation-based rate risk at longer maturities. We have used them from time to time, over the last year, in portfolios with durations of four-years or greater, but have used them only sparingly in shorter portfolios.

Treasury Inflation-Indexed Securities (“TIIS”) can also offer some protection against the less likely economic scenario. The redemption value of TIIS is adjusted for the CPI. In a deflationary environment, this adjustment could be negative. However, the redemption value will not be adjusted below par even when CPI is negative. TIIS, therefore, offer downside protection against a deflationary environment that is inversely proportional to the purchase premium over par.

Chris Kinney provides more detail on inflation-indexed bonds here .

Invest in “Spread Duration”

Moving “down in quality” to corporate bonds is an effective way of reducing interest rate risk. Lower-quality debt obligations pay a higher coupon, therefore, making their Zero-Return Rate Rise substantially higher than Treasuries (see previous Graph 4). In less quantitative terms, the extra coupon in credit spreads provides some cushion to the portfolio’s return if rates rise. As a rule, the lower the credit-quality, the more the bond trades on its credit risk premium.

Graph 8 describes the compelling performance of corporate credits relative to U.S. Treasuries in a flat or rising rate environment.

A conventional recovery involving strengthened earnings would improve credit quality in the corporate sector, thus causing credit spreads to narrow and default and downgrade experience to improve.

Jayant Kumar provides more detail on "Buying Spread Duration and/or Hedging Treasury Duration".

Hedge Treasury Duration

This last technique involves the substantial rate-risk relief of shortened duration, while still accessing the advantages of credit risk at longer ends of the curve. This is a portfolio structure we recommend for two-year investors with large pools of investment assets and guidelines that allow credit risk and derivatives.

In essence, we structure a core-like portfolio of instruments concentrated at the point on the yield curve where spreads exceed U.S. Treasuries by the greatest margin. This point varies over time, but can be as short as three years and as long as eight years. We then use futures or total return swaps to take a short position against U.S. Treasuries of similar duration to our holdings. Thus, the exposure to increasing U.S. Treasury rates is eliminated, while the exposure to spreads (instrument yield less U.S. Treasury yield) remains.

In this way, an investor can capitalize on good credit research, structural risk aversion in the fixed income markets and improving credit fundamentals (when they exist) without undue exposure to the macro interest rate environment.

We offer this combination in a mandate called “LIBOR Plus” and in customized portfolios, although we have used the hedging techniques described above in core mandates as well.

Conclusion

The Fed continues to put monetary stimulus into the economy. The Federal budget has moved back into deficit as Washington continues to spend on Iraq and a variety of domestic programs, and we believe some version of the President’s tax plan will pass. At present, the economy is responding very slowly to this stimulus, but does not appear to be headed to deflation. We do not forecast immediate and substantial movement in interest rates, but we believe the next big move will be up.

In the article above, we have described five ways that fixed income investors can adapt to this unfamiliar risk. Please continue to check in here for more detailed descriptions of these methods and how we presently combine them in client portfolios.

1 Assuming the bond is purchased at par at the stated maturity and held for the period, and that the yield curve does not steepen or flatten.

2 The Sharpe Ratio is the quotient of return divided by volatility. It is used to compare risk-reward relationships between assets.


Mr. Hofer is Director of Fixed Income Research
andrew.hofer@bbh.com

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