In basketball, it’s a half-court shot. In football, it’s a Hail Mary pass. In golf, it’s the eagle on 18. Each of these plays depends on a person directing a ball to follow a very specific trajectory to yield a big return. When it happens, it’s wondrous. However, it’s rarely repeatable, much less by the same person. In fixed income this year, it’s been the aggressive bet on long-end rates.
Without a doubt, in 2014, if you made a large, non-consensus bet on the decline in rates of long-dated fixed income securities (bonds with maturities of 10 years or more), you would have won the jackpot. The longer the maturity, the richer the return has been. The recent 20% return by the Barclays U.S. Treasury: 20+ Year Index makes it the best performing Barclays index so far in 2014. Compare that return to the 10% year-to-date return for the S&P 500 Index and you can quickly see the magnitude of the strong results. In addition, the Barclays U.S. Long Government/Credit Index is up about 16% year to date. These two segments, long Treasurys and long credit, represent only 13% of the Barclays Aggregate Index (Agg), yet, as of October 31, 2014, they have accounted for almost 40% of the Index’s total return this year.
The market calls an audible on rising rates
Most of us (including myself) entered 2014 with a high-conviction view that rates would rise given the Federal Reserve’s (Fed) steps to exit its loose monetary regime amid an improving domestic economy. We felt the foundation for a stronger and more stable recovery was at hand. Unfortunately, this thesis was invalidated early in the year. A winter freeze stalled U.S. growth while the economies of our European trading partners were faltering. Treasury yields fell, and as the year progressed, their decline gathered momentum. Emerging markets weakened and concerns around China’s growth surfaced. With this, the market consensus around rising rates increasingly began to break down. Once rates establish a momentum up or down, no one wants to be on the wrong side of it. The more long rates declined, the more investor anxiety increased about being left behind. This resulted in short covering and general position squaring for many fixed income investors, with a strong round of buying in longer duration bonds.
Concerns around the global economic slowdown hit a climax by autumn, and panic buying in mid-October took yields back to lows not seen since May 2013. The buying pushed the long bond (30-year Treasury) up over five points in one day – a six standard deviation event. The last time we talked in six standard deviation events was in the depths of the financial crisis in 2008.
The long end of the curve is now a crowded trade as investors have shifted to a new consensus view of “lower rates for longer” or the more extreme “interest rates will not rise.” I believe the sharp gains by the long end are not sustainable, and the kind of concentrated bets we’ve seen in the long end aren’t repeatable without taking on an extreme amount of risk.
It’s always possible that the “lower rates for longer” consensus may be right. But, I can also envision a time when instead of the long end generating a positive 25% return, its returns become negative and investors are reminded that betting on the direction of interest rates is a highly risky game – especially with the long bond.
The risks in longer-dated Treasurys have increased
Given the degree to which the Agg’s return this year has been largely supported by a narrow part of the market, it’s appropriate to ask whether downside risk for the Index has increased. Put another way, a concentrated bet on longer-dated bonds would require an even greater move lower by yields to offset the downside risk in price the bonds may now have. In golf, banking on an eagle on 18 to win the match is foolhardy. With yields low and spreads tight, placing that same bet in the long end is a high risk proposition. It runs counter to seeking capital preservation and risk-adjusted returns, the two goals our investment process centers around.
In the near term, I believe the biggest gains in longer-dated Treasurys are largely behind us. We all have been forced to reconsider the risks and rewards within fixed income in light of global economic challenges and geopolitical events (ISIS, Russia/Ukraine tensions, Ebola). All told, valuations on several metrics have become rich. It would not be surprising to see long-end rates range bound through year-end given the divergence of central bank policy and economic growth trajectories. Even if rates remain range bound, the volatility of long-end Treasury prices is significantly elevated for an asset class favored as a “safe haven.”
For example, the implied volatility of the CME Ultra Long Term U.S. Treasury Bond Future (which represents bonds with remaining term to maturity of not less than 25 years) has averaged a full 90% of that of the S&P 500’s over the past three years. The upward momentum of the long bond’s price this year had been masking its volatility. But, the long bond has showed that in short order, its price can fall as much as it rose. Just consider that by October’s end, the long bond’s price had shed all the gains it had garnered during the October 15 rally. In fact, since that rally, implied volatilities for prices throughout the long end of the Treasury curve have risen substantially. Thus, even if the upside of long-end Treasury prices are capped within a range, they’ll give you plenty of volatility to worry about in the meantime.
Could long-end yields decline significantly from here?
There is still good reason for an investor to ask: Why wouldn’t prices of long-end Treasurys continue to rise? After all, the long end of the Treasury curve reflects anticipated inflation and that remains benign thanks in part to falling commodity prices and limited wage growth. Moreover, the eurozone’s growing deflationary pressures could be imported by the U.S. In the
face of a weakening eurozone economy, and a global economic slowdown generally (including China’s), U.S. growth is bound to be questioned. Meanwhile, aggressive monetary stimulus by the eurozone and Japan has created anemic sovereign yields abroad. Yield-hungry foreign investors have stepped up purchases of Treasurys, pushing their yields lower. A strengthening U.S. dollar has only increased Treasury purchases by foreign investors, whose currencies are depreciating against it.
Thus, the answer to the investor’s question is a resounding YES, it’s possible that long-end Treasury prices could continue to rise. But, if you buy into that possibility, consider these implications:
1. Are the factors that could continue to drive long bond outperformance under this scenario relatively bad for the rest of the capital markets? A significant flattening of the yield curve (long rates lower and short rates higher) is most likely met with the entering of a recession. Recessions are generally not friendly to risk assets.
2. Are you also willing to accept the possibility that you could be wrong, and that there is risk of significant negative returns if rates were to rise instead? The positive 25% return very well could be a negative 25% return. I am not sure many investors are comfortable with that return profile from their equity portfolio, let alone from their bond portfolio.
Where does this leave investors?
We could be in the late innings of a 30-plus year bull market in fixed income. Home run investments are harder to come by today with rates having declined to their low levels and at a time when they are showing such high volatility. Many of the potential home runs out there (like concentrated bets in long duration or lower credit quality bonds) could require a significant amount of risk taking, including the possibility of material capital loss.
I still believe that corporate credit offers some of the best risk-adjusted opportunities in fixed income, especially within specific points on the curve. But, security selection is the most important consideration. While the U.S. recovery has matured and the easy money has been made in credit, balance sheets are their strongest in recent history. Given our stage in the economic cycle, however, some companies have begun re-leveraging capital structures (e.g., mergers and acquisitions, stock repurchases). This is to be expected. Today’s low after-tax borrowing cost for companies facilitates a low hurdle rate of return on investments. Take note: The downside risks associated with this corporate re-leveraging activity is carried most by the longest maturing debt of companies.
Let me be clear: There is a place for long-dated Treasurys. But, investors may be better served when longer-dated securities are within a dynamic, actively managed portfolio, which adjusts its exposure to a variety of fixed income sectors depending on valuations and market conditions. Long-dated Treasurys can serve as an “insurance policy” within a portfolio, but the “insurance” must be priced right to serve its purpose.
Singular dramatic plays are great when they work out. In golf, having a well-rounded game, knowing when to keep the driver in the bag, having a strong short game and not missing the easy putts result in a consistent game and a low handicap. In football, it is the consistency of blocking and tackling and running a tight series of plays that result in touchdowns (Bless my Denver Broncos and Peyton Manning).
In investing, the same philosophy and process are important to winning. Balancing risk and reward in a portfolio, avoiding significant downside risk and striving for consistency of returns are the keys to long term success. In fixed income today, this is ever more amplified amid low rates and tight spreads. There are opportunities in today’s fixed income market, but there are not as many as we have seen over the last five years. While investing is not a game, I hope the sports analogies highlight this very challenging environment for investors, especially as it relates to the risk in the long end of the fixed income markets. It is a time to play great defense and smart offense, putting together a series of smart moves that add up to victory. Our scorecard reads risk adjusted returns and preservation of capital.
Investing involves risk, including the possible loss of principal and fluctuation of value.
Past performance is no guarantee of future results.
The views expressed are those of the author, Gibson Smith, and do not necessarily reflect the views of Janus. They are subject to change, and no forecasts can be guaranteed. The comments may not be relied upon as recommendations, investment advice or an indication of trading intent.
There is no assurance that the investment process will consistently lead to successful investing.
In preparing this document, Janus has relied upon and assumed, without independent verification, the accuracy and completeness of all information available from public sources.
Fixed income securities are subject to interest rate, inflation, credit and default risk. The bond market is volatile. As interest rates rise, bond prices usually fall, and vice versa. The return of principal is not guaranteed, and prices may decline if an issuer fails to make timely payments or its credit strength weakens.
When bond valuations fall it is possible for both actively and passively managed investments to lose value.
Barclays U.S. Treasury: 20+ Year Index measures the performance of the U.S. Treasury securities that have a remaining maturity of at least 20 years. S&P 500® Index is a commonly recognized, market capitalization weighted index of 500 widely held equity securities, designed to measure broad U.S. equity performance. Barclays U.S. Long Government/Credit Index measures the investment return of all medium and larger public issues of U.S. Treasury, agency, investment-grade corporate, and investment-grade international dollar-denominated bonds with maturities longer than 10 years. Barclays U.S. Aggregate Bond Index is made up of the Barclays U.S. Government/Corporate Bond Index, Mortgage-Backed Securities Index, and Asset-Backed Securities Index, including securities that are of investment grade quality or better, have at least one year to maturity, and have an outstanding par value of at least $100 million. An investment cannot be made directly in an index.
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