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

Where's the Investment?

I have heard from a number of readers that the lack of consumption in the current environment is not as troubling as one might expect. The thought is that rather than consume, individuals are increasing their level of savings, which is just a form of future consumption (and the opportunity to consume MORE later outweighs the benefit of consuming LESS now).

Which makes sense, except the data does not support this theory. Looking at the data, we see a HUGE decline in investment (and thus a HUGE decline in savings if you assume I = S). How large? Investment is down massively from its 2005 peak across the board and is now below the level of investment seen in Q2 1997.

Twelve years of growth in investment gone? What is happening? Well, the savings that has been reported is not occurring as the numbers imply. Savings is calculated as the difference between income and consumption. What is missing is interest payment / debt repayment. As described by reader Angry Saver in a previous post:

The C+I... formula is simplistic and rests on flawed assumptions. It is an accounting identity that does not always reflect the facts in the real world. End demand by consumers is the key. When end demand shrinks, so does the pie. When future income shrinks, so does the pie. Adding gov't debt will create false demand and may keep the debt system from imploding, but it will also limit future end demand.

(We've) spent too much based on misperceptions of future wealth (wall street lies). Much of the so-called investment/savings were borrowed from abroad and were actually malinvestments as they exceeded ability to pay and were not based on end demand. The bills for all that excess/mis-spending are now due. A rude awakening. Debt repayments and debt defaults at the household level will accelerate.

Despite propaganda to the contrary, U.S. consumers are now realizing that their future incomes will be less than previously thought. Lower savings/investment is to be expected as our economic future will be smaller than previously assumed.

Source: BEA

The Worrying I in C + I + G + NX

The final figures for Q1 GDP were released this morning and although nothing drastically changed (revised up to -5.5% from -5.7%), the figures for non-residential investment are still important to review.

Investment is important to long-term economic growth and/or recovery. One such study by Brad De Long and Larry Summers on the relationship between equipment investment and economic growth noted:

We find that producers’ machinery and equipment has a very strong association with growth: in our cross section of nations each percent of GDP invested in equipment raises GDP growth rate by 1/3 of a percentage point per year. This is a much stronger association than can be found between any of the other components.

For that reason, a massive drop in investment is not only cause for concern now, but for future and lasting economic growth. And the size of the drop in investment is massive.



Source: BEA

Investment Slump

Marketwatch reports:

The big story for the first quarter was in the business sector, where firms halted new investments, and shed workers and inventories at a dizzying pace to bring down production and stockpiles to match the lower demand from U.S. and foreign markets.

"Businesses have not only cut back aggressively on inventories, but also on business fixed investment," wrote Harm Bandholz, economist for UniCredit Markets. "And the size of the declines in suggests that the adjustments in these areas have largely been made during the last couple of months."

Source: BEA