Bonds

Curves Ahead!

US stocks have been mostly down lately. Domestic stocks had largely defied the selloff seen in global markets for much of the year, but recently have given back most of their year-to-date gains. Some point to the slowdown as being caused by new tariffs resulting from trade disputes with China. Others suggest it is due to rising interest rates, primarily on the short-term end of the market.

Put simply, if the Fed wants to cool off the economy, they can raise the interest rates that banks pay for short term borrowing. Those higher costs are then passed on to borrowers, making people less likely to take out loans. Fewer loans equals less investment and spending, which leads to less economic activity. Usually, when the Fed is worried about a hot economy, long-term rates also rise as inflation concerns increase.

Sometimes, however, longer term interest rates stay down while the Fed raises short term rates. This is because longer term rates are market driven. If the market doesn’t collectively believe the economy is heating up enough to create inflation, then long term interest rates will typically stay low.

A yield curve gives a snapshot of how yields vary across bonds of similar credit quality, but different maturities, at a specific point in time. For example, the US Treasury yield curve indicates the yields of US Treasury bonds across a range of maturities. Bond yields change as markets digest news and events around the world, which also causes yield curves to move and change shape over time.

Historically, yield curves have mostly been upwardly sloping (short-term rates lower than long-term rates), but when short term rates and long-term rates are about the same, it is referred to as a flat yield curve. When short term rates exceed those with longer terms, it is called an inverted curve. Stock market investors get nervous as yield curves flatten. That is mainly because the central bankers seem to be trying to take fuel from a fire that the bond market considers to be under control. The fear for equity investors is that the Fed will totally extinguish the economy, sending us into recession.

So, are flat or inverted curves something to fear?

Have We Seen This Movie?

Movie Night.jpg
There are some moments that mark your life, moments when you realize nothing will ever be the same. And time is divided into two parts, before this and after this. – John Hobbes (Fallen)

In the summer of 1977, my mother, brother, and I made our much-anticipated annual trip from our small East Texas hometown to the Dallas-Fort Worth Metroplex to visit my aunt and uncle. The big city offered us the opportunity to see and do things that weren't normally options at home, but the highlight was always a visit to our version of the happiest place in Texas (sorry Walt), the Six Flags Over Texas amusement park.

On the morning after Six Flags, I heard my aunt and mother discussing what we were going to do for the remainder of our stay. The plan for that day was to head to the shopping mall to buy back-to-school clothes for me and my brother. Coming from a small town with only a couple of department stores to choose from, the idea of literally having dozens of places to shop for deals under one roof was exciting…. for the adults.

My brother and I, however, weren’t eager to spend the day trying on new shoes and blue jeans. My aunt, noting our lack of enthusiasm, pulled out the newspaper and suggested we pick a movie to go watch at the mall theater. I recall that the listings took up an entire page of the paper. In the middle of the page there was an advertisement that included the image of what looked like a dark robot wearing a gas mask and German storm trooper helmet. 

We had no idea what Star Wars Episode IV: A New Hope was about, but Mom thought Smokey and the Bandit may be a bit racy for my 7 year old brother. That narrowed our choices to Benji, Herbie, or the cool looking "robot". Little did we know that after the trip to the mall that day that nothing would ever be the same.

In the days before VCRs, DVR's, and Netflix, the movie experience was more than an activity, it was an event. Star Wars was one of only 54 movie releases in 1977 per the movie data website, The Numbers®. Compare that to this year, where 83 movies were released, in JANUARY.

Watching a movie today is almost as routine as watching reruns of The Brady Bunch was not so long ago. Now, with so many more flicks to choose from coupled with the ability to stream just about any of them through our home theaters or various other devices, it’s not that unusual to realize that you've already seen a movie after the first scene or two.

This week, that familiar feeling came over me while watching a business channel. The headline flashed that the Fed had “surprised” markets by raising rates for just the second time in a decade, boosting the rate that banks can lend each other money overnight from .5% to .75%. The stock markets soon lost about 2% of their value, mostly attributed to the rate increase.

There were plenty of commentators predicting the calamity that would result from this “unexpected” increase in rates. Then I realized why it felt like Déjà vu when I looked back at the Accountable Update I wrote about this time last year. In the 12/18/15 installment titled Staying Out of Trouble, I noted that the Fed had just raised fed funds rate by .25% and that they anticipated additional moves by up to 1% in 2016. Sound familiar?

The same people on the business channel were saying the exact same things they said last year, “Get out of bonds! Buy a house now before higher rates make them unaffordable! Don’t invest your cash, wait for higher rates! This is the beginning of the end! Buy gold before it’s too late!”

Eventually, the broken clocks will be right, for a moment. We prefer to have a plan for each of our clients that relies on evidence instead of guesses. The odds are this isn’t a defining moment that we will look back upon one day. It’s much more likely that this is just another movie that we’ve seen before. If you would appreciate a more in-depth look at some of the evidence, please enjoy the following Issue Brief from DFA’s, Doug Longo.

If not, head to the mall. There are only 9 shopping days until Christmas!

 


The Fed, Yields, and Expected Returns

Doug Longo
Dimensional Fund Advisors
Fixed Income Investment Strategist

December 2016

In liquid and competitive markets, current interest rates represent the expected probability of all foreseeable actions by the Fed and other market forces.

On December 14, 2016, the Federal Open Market Committee (Fed) concluded its final meeting for the year and announced its decision to raise the federal funds target rate from its range of 0.25%–0.50% to 0.50%–0.75%.

As we have mentioned before, Fed watching is a favorite pastime for many market participants who often presume that Fed actions will lead to specific market outcomes. On December 16, 2015, the Fed raised the federal funds target rate for the first time since 2006. As a result, some market commentators believed this was a signal that multiple rate increases would occur in 2016.

As we now know, the Fed failed to prove the market prognosticators right; the Fed did not change the target rate until its last meeting of the year. Despite this, interest rates in the US have varied throughout the year. In fact, as shown in Exhibit 1, immediately following the Fed’s rate increase in 2015, yields on many US treasury bonds decreased until the second half of 2016.

Exhibit 1.       US Treasury Yields (%) as of December 14, 2016

Securities data provided by Bloomberg Barclays LIVE. Bloomberg Barclays data provided by Bloomberg.

Securities data provided by Bloomberg Barclays LIVE. Bloomberg Barclays data provided by Bloomberg.

 

Because interest rates in the US began to increase at the beginning of the fourth quarter, it prompts a question: Did the market lead the Fed to raise its key interest rate, or did the Fed lead interest rates higher by setting expectations?

Trying to answer the question may be futile, however. In liquid and competitive markets such as the US Treasury market, current interest rates represent the expected probability of all foreseeable actions by the Fed and other market forces. Market participants, using publicly available information, estimate the probabilities of different outcomes. Those expectations are collectively reflected in current interest rates. As publicly available information changes, market participants adjust their expectations, which are immediately reflected in new interest rates.

While market participants use publicly available information to set expectations, unanticipated future events or surprises relative to those expectations may trigger interest rate changes in the future. The nature of those surprises cannot be known by investors today. As a result, there has been no reliable way found to systematically benefit from trying to outguess market prices when forecasting changes in interest rates. We can say, however, that there is known and observable information in current interest rates, or bond prices, that we can use to set expectations about future returns.

The expected return of a bond can be decomposed into three components: (1) the yield of a bond over its holding period; (2) capital appreciation (or depreciation) of the bond due to the shape of the yield curve; (3) and changes in bond prices due to future changes in yields. As we mentioned earlier, there is no reliable way to predict future changes in yields due to unanticipated future events that are not yet known.

Our research and experience in the fixed income markets informs us that there is reliable information in the first two components of expected return that enables us to use current bond prices to identify securities with higher expected returns.

As we can observe in Exhibit 2, yields on US Treasury bonds have increased since the end of September. While the increase in yields has had a negative impact on fixed income returns over the short term, the expected returns of fixed income securities, as observed through the first two components of expected return, have increased.

The first component (yield) has increased as bond prices have decreased. Additionally, as yields on longer-term bonds have increased more, relative to shorter-term bonds, the shape of the yield curve has become steeper. A steeper yield curve increases the second component of expected return (capital gain). As time passes, a bond’s maturity and yield decrease as the bond becomes a shorter-term bond. On an upward sloping yield curve, this results in capital appreciation. As a result, the expected capital gain is greater for bonds on steeper yield curves if those bonds are sold before maturity.

We believe using information about expected returns in current prices combined with a long-term focus can serve investors well when pursuing investment goals. So while yields have increased over the fourth quarter, prices today indicate that forward looking expected returns have also increased.[1]

Exhibit 2.       US Treasury Yields (%) as of December 14, 2016

Source: US Department of the Treasury.

Source: US Department of the Treasury.

 

 

[1]    Fixed income securities are subject to increased loss of principal during periods of rising interest rates and may be subject to various other risks, including changes in credit quality, liquidity, prepayments, and other factors. Sector-specific investments can increase these risks.

Dimensional Fund Advisors LP ("Dimensional") is an investment advisor registered with the Securities and Exchange Commission. 

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. This content is provided for informational purposes, and it is not to be construed as an offer, solicitation, recommendation or endorsement of any particular security, products, or services. 

Negative Real Returns

"Every single human being" should short treasuries.

So said Nassim Nicholas Taleb, speaking at a conference in Moscow on February 4, 2010. Taleb, you may recall, rose to fame with his 2007 book, "The Black Swan". In the book , he discusses the impact of unpredictable, low probability events and our tendency to oversimplify explanations for them after the fact. The timing of the publication, just before the mortgage crisis and stock market meltdown, resulted in Taleb being a frequent commentator in the financial press. His views most often represented cynical spins on markets and the economy.

He also recommended buying gold in that same speech.

To his credit, in a recent commencement address at American University of Beirut, he also said, 

"I hesitate to give advice because every major single piece of advice I was given turned out to be wrong and I am glad I didn’t follow them....
...If you give advice, you need to be exposed to losses from it."

While hindsight is 20/20, history teaches us that making these kind of prognostications are just as likely to make you infamous as they are to make you famous. Let's look at how Taleb's thoughts on US Treasury Bonds worked out.

I used Kwanti Portfolio Labs portfolio analytics software to compare three hypothetical investments results made on the day of his Moscow presentation through yesterday, 9/1/16. The investments were DFA Intermediate Government Fixed Income Portfolio (DFIGX), the Barclays US Treasury Long Index, and the Gold Spot price. As you can see from the chart below, gold was the worst performer of the bunch. Had you been short treasuries, those returns would have been essentially THE INVERSE (plus borrowing costs) of what you see reflected.

All of this is not to pick on Mr. Taleb. He is one of a handful of reliable pessimists that any "half empty glass" world view TV show, magazine writer, or forum will put in front of microphone when that perspective is desired. There are just as many "sunshine pumpers" alternately offered for opposing views.   

The criticism I offer is that much less exciting, yet evidenced based, approaches have shown that the main factors influencing the price of bonds are the length of maturity (term) and the underlying credit quality (credit). Pursuing strategies that seek to take advantage of these premiums have been effective, especially when real returns (after inflation) have been negative in many countries for the past few years.

The following "Issue Brief" from DFA delves into this a little further.


Negative Real Returns

September 2016

Nominal interest rates are currently below zero in many countries, including Germany, Denmark, Switzerland, Sweden, and Japan.

These levels have turned the common belief that zero is the lower bound for such rates on its head. While negative nominal rates are a relatively new phenomenon, periods of widespread negative real returns across countries have been quite common.

WHY CARE ABOUT REAL RATES OF RETURN?

In 1970, a loaf of bread cost 25 cents. A gallon of gas cost 36 cents. Today, an average loaf of bread and a gallon of gas each cost around two dollars.[1] When the prices of goods and services increase, consumers can buy fewer of them with every dollar they have saved. This is called inflation, and it eats into investors’ returns.

Real rates of return are adjusted for inflation, so they account for changes in the purchasing power of a dollar over the life of an investment. Because inflation affects the cost of living, investors must consider the inflation-adjusted—or real—return of their investments. When inflation outpaces the nominal returns on an investment, investors experience negative real returns and actually lose purchasing power.

BRIEF HISTORY: TREASURY BILL RETURNS

Exhibit 1 shows the annual real returns on one-month US Treasury bills. From 2009 to 2015, the annual real return was negative. This circumstance is not unprecedented. Since 1900, the US has had negative real returns in over a third of those years. And negative real returns on government bills are not exclusive to the US. All countries listed in Exhibit 2 have had negative real returns on their respective government bills in at least one out of every five years from 1900 to 2015.

Exhibit 1.            Annual Real Returns of One-Month US Treasury Bills   Source: Dimson, Marsh, and Staunton (DMS); Morningstar.

Exhibit 1.       Annual Real Returns of One-Month US Treasury Bills
Source: Dimson, Marsh, and Staunton (DMS); Morningstar.

Exhibit 2.            Percent of Years with Negative Real Returns on Government Bills, 1900–2015   Source: Dimson, Marsh, and Staunton (DMS); Morningstar.

Exhibit 2.       Percent of Years with Negative Real Returns on Government Bills, 1900–2015
Source: Dimson, Marsh, and Staunton (DMS); Morningstar.

BOND INVESTORS MAY GET MORE THAN THE BILL RETURN

In the current low-yield environment, rolling over short-term bills may not seem appealing to investors keen on protecting their purchasing power. Exhibit 3 shows that the return of one-month US Treasury bills has not kept pace with inflation[3] over the past 10 years. But even when the real return on bills is negative, a relatively common occurrence, bond investors may still achieve positive expected real returns by broadening their investment universe. The bond market is composed of thousands of global bonds with different characteristics. Many of those bonds allow investors to target global term and credit premiums, which in turn may provide positive real returns even in low interest rate environments. Exhibit 3 also shows that the Barclays Global Aggregate Bond Index has outpaced inflation while maintaining low real return volatility of 3.4% annualized over the past 10 years.

Exhibit 3.            Trailing Annualized Returns   Past performance is not a guarantee of future results. Indices are not available for direct investment; therefore, their performance does not reflect the expenses associated with the management of an actual portfolio. Trailing returns are as of June 2016. The Barclays Global Aggregate Bond Index is hedged to USD. Real Return = [(1 + Nominal Return)/(1 + Inflation)] − 1. Sources: Barclays, Morningstar. Barclays indices copyright Barclays 2016.

Exhibit 3.       Trailing Annualized Returns
Past performance is not a guarantee of future results. Indices are not available for direct investment; therefore, their performance does not reflect the expenses associated with the management of an actual portfolio. Trailing returns are as of June 2016. The Barclays Global Aggregate Bond Index is hedged to USD. Real Return = [(1 + Nominal Return)/(1 + Inflation)] − 1. Sources: Barclays, Morningstar. Barclays indices copyright Barclays 2016.

Global diversification is often thought of as a tool for reducing risk. However, when it comes to fixed income, global portfolios can also play an important role in the pursuit of increased expected returns. Even if the expected real returns of bonds in one country are negative, another yield curve may provide positive expected real returns. The flexibility to pursue higher expected returns by investing in bonds around the world can be an important defense against low, and even negative, yields.

SUMMARY

The goal of many investors is to grow some (or all) of their savings in real terms. Even in a low interest rate environment, there may be bond investments that can still achieve this goal. In particular, investors who target global term and credit premiums should be better positioned to pursue higher expected returns.

 

[1]. Source: Bureau of Labor Statistics.

[2]. Measured as changes in the Consumer Price Index (CPI), which is defined by the US Department of Labor, Bureau of Labor and Statistics.

[3]. Measured as changes in the Consumer Price Index (CPI), which is defined by the US Department of Labor, Bureau of Labor and Statistics.    

 

Source: Dimensional Fund Advisors LP.

All expressions of opinion are subject to change. This information is intended for educational purposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, products, or services.

Past performance is no guarantee of future results. There is no guarantee an investing strategy will be successful. Diversification does not eliminate the risk of market loss.