Tuesday, April 13, 2010

Investing in a Low Return Environment... It's All Relative

There seems to be a growing number of articles these days detailing the concern that rising rates will have a dramatic impact on bond performance going forward (see WSJ's The Risk of Rising Interest Rates and the NY Times' Interest Rates Have Nowhere to Go but Up). While I am less certain that rates will in fact rise over the near term (call me a contrarian), I think these articles miss the broader picture and as a result are focusing too much on rising rates rather than the issue facing investors across all asset classes. Specifically, that an investor (unfortunately) is required to take on a much higher level of risk than in the past to get any level of attractive absolute return.

But, since these articles have focused on bonds, lets focus on bonds.

Looking at the Barclays Capital Aggregate Bond Index "BarCap Agg", one of the most widely used benchmarks to represent high-quality investment grade bonds, the chart below shows the yield to worst "YTW" and the duration of the index going back 20 years. As can be seen, these two levels have crossed as the yield of the benchmark continues to ratchet down to historic lows.

Why does this matter? Well if the YTW is less than the duration, that means if interest rates rise across the yield curve by 100 bps (i.e. 1%) or more in the next 12 months, then the yield of the portfolio (i.e. carry) will not make up for the loss an investor realizes from the price impact of rising rates (this ignores convexity, but a duration of 1 roughly means that if rates rise 1%, the portfolio sells off by 1% all else equal).

Lets dive deeper and take a look at the ratio of YTW to duration. At the end of March, the YTW of the BarCap Agg was 3.46%, while the duration was 4.68 years (3.46 / 4.68 = ratio of 0.74). At this point, if rates rise by 74 bps across the entire yield curve, the price impact of the portfolio = -3.46% (-0.74 * 4.68), exactly offsets the yield of the portfolio 3.46%, thus TOTAL returns over a 12 month period would equal zero (again, ignoring convexity).

Below is a historical look at that ratio (we'll call it the Duration Coverage ratio) vs. 12 month forward returns of the BarCap Agg. Interestingly enough, the ratio has closely tracked performance. One thought is that the Duration Coverage ratio shows how much an investor is being compensated for taking risk; when the ratio is low, they are not being compensated much (thus the lower returns on a going forward basis).

So bonds are rich and duration should be avoided at all costs? Hardly.

This type of thinking made sense when one could focus solely on absolute terms. There is no question that an investor is not being compensated much in absolute terms to take on duration risk. But, this should not be a surprise when one considers return expectations for less risky investments. Shown below is the difference between the yield on the ten year and two year Treasury... it is now at historic wide levels (the green line).

As a result, while an investor is not being compensated much to take on duration risk in absolute terms (the ten year yield is low), they are in relative terms as the two year bond was yielding a measly 0.96% at the end of March. The chart below shows the same rolling Duration Coverage as the chart above with one exception... that being the YTW is adjusted by subtracting out the two year Treasury yield to put it in "relative" terms. This changes the story completely. Rather than appearing rich, the relative duration coverage now seems cheap compared to historical levels.

And THAT'S the problem with investing these days (and not just with bonds). With risk-free rates hovering near zero, an investor must take a much larger amount of risk to achieve any level of absolute return. This concept is even more meaningful for an investment in risk assets, such as equities and commodities, as the downside risks of those asset classes are MUCH higher than even the worst case rising rate scenario on an investment in the BarCap Agg.

As a result, the question for all investors should be how comfortable you are taking risk to get a return ON your capital and not just a return OF your capital?

The issue is that a lot of investors don't realize this question needs to be answered.

Source: Federal Reserve / Barclays Capital


  1. Insightful and thought-provoking; thanks!

    I guess this is exactly the intention of the Fed.

  2. it is the intention of the Fed and it is right to look at returns on a relative basis as well as am absolute basis. Two things though. One, whilst it is exactly right to say that the Fed's intention is to force investors out of cash/short bonds and into high risk assets, it is not true to say that relative returns are worth pursuing when all the returns are likely to be negative and it is just a question of how negative. Rather like the fund manager saying they beat an index that fell 50%; who cares? The better question to ask is how the link between savings and investment performs when the market is broken and the Fed has flooded the cash market and manipulated the long bond rate. I dont think the Fed has any more prescience than a bag lady, so the moral hazard here is also clear. The Fed's actions prevent the rational allocation of capital and prevent savings being turned to investment. The result is the path to the third lost decade that Japan has followed. Remember when the Nikkei peaked at 39,000 in 1991, compared to 11,000 now? This is the true cost of a central bank distortion of the link betwen savings and investment whilst the Governmnet crowds out the private sector and you have debt saturation.

  3. hooligan- that is exactly why i brought up the following:

    "As a result, the question for all investors should be how comfortable you are taking risk to get a return ON your capital and not just a return OF your capital?"