The Impact of Interest Rate Changes (Part 2)

Yesterday's post set the groundwork for understanding the mechanics of getting an approximation for the impact of a change of interest rates on portfolio return.  The poll by Edward Jones revealed that many investors are confused by the impact.  This isn't good because investors, and especially retirees, have piled into bonds and bond funds over the past several years in search of yield as the Federal Reserve and global central banks have driven short-term yields close to zero.

So let's take another look at this important influence on portfolio return.  Suppose we agree with what seems to be the consensus - that rates will move higher over the long term -  but still appreciate the fact that the consensus could be wrong and that rates could stay fairly stable or even drop from here. Assume further that our asset allocation calls for 40% of investable assets in fixed income.

One way to play this would be to invest 50% of the fixed income portion in CSJ and 50% in AGG. CSJ lowers the yield of the fixed income portion but also reduces considerably the price volatility.  In other words, it is a bit of a hedge relative to the overall bond market.

Following the approach presented yesterday, we would go to Morningstar and get the yield and the duration of CSJ and AGG.  The yields are 0.86% and 2.40% for CSJ and AGG respectively.  The durations are 1.96 years and 5.08 years for CSJ and AGG respectively.

So what would be the approximate impact if yields rose 1.50% (10-year Treasury yield rises from 2.80% to 4.30%) over, say, the next 6 months?  To figure this out, note that the bond portfolio is equivalent to having an ETF with a yield of (.86 + 2.4)/2 = 1.63% and a duration of  (1.96 + 5.08) = 3.52 years.

The impact of a 1.50% rise over 6 months could then be approximated at -3.52 * 1.5 =  -5.28 (price change) plus 1.63/2 = .815, or a total impact of -4.465%.  This, of course, will be multiplied by .4 because the fixed income portion represents 40% of portfolio assets.

It is important to understand that the short-cut method here is an approximation.  The actual outcome will be influenced by the shape of the yield curve (short-term rates and long-term rates don't all fall by the same amount), the actual accrued interest on the ETFs, and even the premium or discount on the ETFs relative to their respective NAVs.  Still the approximation shown here should help in lessening the surprise investors could get with a sharp rise in rates.

Dividends vs. Bond Yields

Dividend Payers vs. Bonds

The battle between dividends and bond yields rages on.  Times are atypical.  Typically, a bond allocation can easily be met by buying a well-diversified portfolio of bonds tracking the overall market--an ETF that tracks the Barclay's Aggregate Index, such as AGG or SCHZ.

But today the 10-year Treasury note yields 1.7% and high risk bonds trade at historically low-yield spreads.  Furthermore, investors are becoming more aware of bond market risks.  They are more aware of falling prices as yields rise, and junk bonds facing yield spread widening risk in the event the economy surprises on the downside.

Understandably, investors, including especially those in retirement or close to retirement, are looking around.  Stocks with dividend payouts exceeding the yields on their bonds have caught their eye.

Not only are investors using dividend stocks in the stock allocation portion of the portfolio, they are also substituting dividend stocks for fixed income.  The thought here is to forget about price and focus on dividend yield.  Hold for the long run and seek issues with a history of raising the dividend.  **Think about this:  if you have $1.0 million and need $30,000/year, then a portfolio of stocks that paid 3% and had a history of raising dividends might be interesting to consider.  Along these lines, how would one find such a listing?

Today this is actually quite easy to do, given the excellent research and writings of dividend bloggers. Here is a recent posting by Dividend Growth Investor, one of the best in this genre:  "Dividend Investing Articles to Enjoy."  In the post, the first article contains a favorite listing by Dave Fish which has an Excel spread sheet listing companies with at least 25 years of increasing dividends.  This is an excellent source for dividend investors.

You'll also want to read the article from Dividend Ninja's site on why dividend stocks are not bond substitutes.  This, obviously, argues against the view up for consideration here; but it is good to consider different points of view.

In fact, I would argue for thinking about over-allocating to the stock allocation by 10% (for example, if the allocation is 60% stocks, make it 70%) with strong dividend payers and under-allocating by the same 10% to the fixed income portion.

**There are two ways to construct a portfolio.  The predominant way is with a view towards beating the market in terms of total return.  The second way, that is little discussed but seems to be a driving force among those building dividend portfolios, is to construct a portfolio to yield a given income stream with little thought to the price movement of the assets - especially over the short term.

Disclosure:  Investors should do their own research or consult a professional before making investment decisions.  The information here is for educational purposes.

Bond Market Sector Choice

A lot of ink has been spilled on the bond bubble theme and the concern that investors are in for a shock if yields rise sharply. Part of this involves extending duration and part is about going into riskier parts of the bond market.

The question here is:  is this a good time to add riskier sectors?  How do professional bond traders approach this question?

Close followers of the bond market contrast the present situation with the recent past.  In the past, the bond portion of an asset allocation could easily be satisfied with an index fund tracking Barclay's Aggregate Index.  This index is a market-weighted index comprised of investment grade issues having a maturity greater than one year.  It includes Corporate Bonds, U.S. Agency issues, Mortgage-Backed securities, and U.S. Treasuries.

But this was in the old days.  This was when the 10-year Treasury note yielded north of 4%.  Today the yield is 1.77%.  Furthermore, the duration on the index is 4.4 years and the index yield is 1.6% (SEC yield).  Also, as the U.S. Treasury has run chronic deficits exceeding $1 trillion, the U.S. Treasury portion of the index has expanded to comprise greater than 30% of the Barclay's index.

These developments are the culprit behind the well-publicized search for yield.  This search has led investors to high yield bonds, emerging market bonds, and other nooks of the fixed income market.

Professionals Trade the Spread

Professional bond traders look not just at maturity and duration but also at spreads.  They ask, for example, whether the yield spread on corporate bonds as a sector compensates for the incremental risk.

Recall that bond prices rise when yields decline.  Consider bond A (a corporate bond) and bond B (a similar Treasury note ).  Assume that Bond A yields 1.50% more than B, i.e., the spread is 150 basis points.  If the spread narrows to 1.20%, say, then that means that the price of bond A has appreciated relative to bond B.

Typically there is a big deal made about regression to the mean, so the idea is to buy when spreads are wide and sell when spreads are tight and then profit when spreads return to their mean.  This is not easy to do, as most professional bond traders will attest, but it is the objective.  Some are adamant that spreads are easier to trade than levels.  If you don't buy this, just recall that almost everyone in the market last year this time were absolutely certain that yields would rise in 2012!

So,what does a yield graph look like and what is it telling us?  CLICK IMAGE TO ENLARGE

This is a comprehensive spread graph.  It is for the overall investment grade market and adjusts for prepayment options and callability, etc.  See the description at the link for a complete definition.

The graph reveals that spreads are fairly tight, i.e, the bond market today isn't offering great compensation for taking on sector risk despite the low Treasury yields.

Some would argue that, if spreads tighten a bit more too close to the 1% level, it would be a good exit point.

You'll note that the best time to invest is, in fact, the scariest.  THERE'S NO FREE LUNCH HERE! Back in 2009, the spread exceeded 6%; but this was when the economy was imploding, bankruptcies were rampant, and corporate bond downgrades were on the rise.  The financial sector was especially taking it on the chin.

Disclosure:  This information is for educational purposes only.  Individuals should do their own research or consult a professional before making investment decisions.

Yield Curve - Part 2

In "Yield Curve - Part 1," we looked at the Treasury yield curve - which shows the yields of "on-the-run" Treasuries. On the run Treasuries are the most recently issued Treasuries. Bond investors study the curve to determine if the pick-up in yield for extending maturity (i.e. buying bonds with a longer maturity) is worth the incremental risk. For example, the yield on the 10-year today is 2.55% and the yield on the 2-year is a pathetic 0.35%. Is it worth taking on the additional risk of the 10-year bond (its price will drop sharply if interest rates rise) to pick up an additional 2.10% (i.e. 210 basis points) in yield? There is no way to get around this fundamental trade-off between risk and return.

Analysts study the curve to assess the likely course of the economy. A steep curve (i.e. the yield on longer-term bonds is considerably above shorter-term bonds) typically indicates a pick-up in economic activity. A steep curve is generally the result of an aggressive Fed pushing short-term rates lower. Today's curve is steep.

A flat or inverted curve typically presages a slowing economy. It generally follows an aggressive Fed-tightening move whereby short-term rates are driven higher. If we experience an inflationary episode in the coming years, this is probably what we'll see.

As a point of useful information, it is generally agreed that the Fed controls short-term rates by targeting the federal funds rate at its FOMC meeting; and longer-term rates reflect inflationary expectations.

In today's environment, the Fed seems to be trying (and succeeding somewhat) to influence longer-term rates by its so-called policy of "quantitative easing." This policy involves buying longer-term securities which pushes their prices higher and yields lower.

Although the Treasury yield curve is the most closely followed, there are others worth knowing about. One such is the TIPS curve which shows the yield on various maturity Treasury Inflation Protected bonds. This curve can be found at the Bloomberg site :

CLICK TO ENLARGE Analysts like to take the difference between the 10-year Treasury and the 10-year TIPS as a measure of inflationary expectations. Today that difference is 2.12% (2.54 - .42). If you buy the 10-year TIPS and inflation averages greater than 2.12%, you are better off versus the non-inflation adjusted Treasury because the principal amount on the TIPS is adjusted upwards by the rate of inflation. The 2.12% is viewed as the break-even rate.

Interest Rate Watch - 2 year Treasury Auction Results

If you followed Monday's post and went to the Bloomberg site as explained, you saw that "...dealers were forced to take down 59% of the month's $37 billion offering" of this month's
2-year Treasury note auction. This, of course, is not good because it indicates that non-competitive bids were weak. As we know, individuals have been pouring into bonds. This could be an indication that this may be nearing an end.

The Bid/Cover ratio was 3.12, which was assessed as "respectable".

The stop-out rate, which indicates the highest rate the Treasury had to pay, was .498%. The Treasury starts with the lowest yields, takes the non-competitive bids next, and then the higher bids (in terms of yield, remember higher yields mean lower prices in bond land!).

Today's auction is for $36 billion of 5-year Treasury notes. Results will be available on the Bloomberg site, or CNBC, shortly after 1 pm.

A couple of extra points to note on the process. You may have wondered about the possibility of the embarrassing situation of the Treasury not being able to attract enough bids for its auction. You can stop worrying. There are 17 designated primary dealers. They have to bid on the auctions. If prior to 1 pm Treasury had not received enough bids, they would do another round with their primary dealers and tell them to increase the amount they are bidding on.

Secondly, a good way for individuals to participate in these auctions ( although I'm not sure why they would want to at these low yields) is to go to Treasury Direct - a site where they can open up an account and participate commission free.

Finally, note that the Treasury is doing the auction. It is the government's bank. To the extent that the Federal Reserve (the Central Bank - a completely different entity) buys and sells Treasury securities, it is changing the reserves in the banking system and thereby changing the nation's money supply (especially when banks are in the mood to lend).

I sure this is more than some of you cared to know about this process, but happy Treasury auction following!

Is There a Limb Getting Ready to Break?

The investment pros have been wrong along with most everyone else, except maybe for the small investor, in predicting a rise in interest rates. The yield on the 10 year Treasury note has fallen to a 16 month low. Amid the pros continual tsk tsking, the small investor has continued to pile into bond funds. Although this extreme drop in rates could very well be a bubble and come back to severely punish the small investor, it has been a very rewarding move up to this point.
In my experience, when these kinds of moves take place, there is the potential for a big accident. Simply, when the pros believe a move in prices is a sure thing (i.e. a drop in bond prices), they bet heavily on it. Unlike you and me (hopefully), they don't just put their money on i-- they borrow to the hilt and put it into the pot. For example, Paulson bet heavily on the housing bubble and won - from a no name hedge fund manager he vaulted to guru du jour. The rest of the banking system made leveraged bets on mortgage backed securities and insuring various instruments - and the American tax payer lost big time. Long-Term Capital Management bet heavily on mean reversion for global spreads and lost--the Fed had to be called in to engineer a bailout.

Very likely there is a trader somewhere - in a hedge fund or in a bank - who has made a heavy leveraged bet on rising rates and who is bathed in sweat night after night praying for rates to rise. The limb is bending mightily. To say the least, if it does occur, the timing couldn't be worse. The Fed is out of ammunition, basically proclaiming this past week that the printing presses are going to remain wide open.

Just some thoughts.

Global Bond Yields

Globally, bond yields tend to move together as traders arbitrage by trading the debt of various countries. This past week (as shown below), the yield on the 10-year U.S. Treasury rose sharply while yields on the same maturity in other countries were mixed. Given the poor results of the past week's auctions, and the data from the Treasury International Capital Report, this may be another indicator that the long-awaited rise in rates has started. Investors in bonds need to be cautious.

                                   3/5       3/12     3/19       3/26
10 yr.German             3.16      3.17     3.11       3.15
10 yr. Italy                 3.95      3.96     3.95       3.92
10 yr. UK                  4.06      4.1       3.95       4.04
10 yr. Japan               1.32      1.35     1.37       1.38
10 yr Australia            5.48     5.69     5.68       5.75
10 yr.U.S.                  3.68     3.7       3.69       3.85