Record-low Treasury bond yields

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1 A reprinted article from January/February 2014 IMCA Investment Management Consultants Association A ROADMAP FOR TRUSTEES AND FIDUCIARIES Examining Volatility in Fixed-Income Portfolios By David J. Gordon, CFP, CIMA Record-low Treasury bond yields have posed a difficult challenge for fixed-income investors. Rising interest rates, however, represent an even more serious threat. Consider that a 1-percent rise in interest rates in today s markets can trigger a 14-percent decline in the value of a 30-year Treasury bond portfolio, or a 4-percent decline in the value of a five-year AAA-rated bond portfolio. How can fiduciaries and trustees seek to protect themselves? Understanding Duration Most fixed-income investors recognize that price sensitivity of bonds is directly related to maturity date. The longer the maturity, the more volatile the price movement when interest rates fluctuate. However, maturity isn t the only factor to consider. Take this test: Given a change in market interest rates, which bond will exhibit the least amount of price sensitivity assuming a 4-percent discount rate a 20-year bond at 4 percent trading at par (maturity value) or a 25-year bond at 6 percent trading above par (a premium)? In this case, the longer maturity will suffer less loss if interest rates rise. To avoid the pitfalls of an overly simplified expectation, fiduciaries and trustees should consider not only maturities but coupon payments, prevailing market rates, assumed reinvestment rates for coupon payments, and acquisition costs (premium or discount) when attempting to account for and predict bond price volatility. Later in this article, credit ratings will also be considered. In 1938, Frederick Macaulay created a formula, which he termed duration, to assess the degree and impact of interestrate volatility in bond prices. His formula was based upon the weighted average term-to-maturity (WAT) of the bond s cash flow. Using the present value of each cashflow receipt as a percentage of the present value of total cash flows, he created a weighting system that provided a result that was expressed in terms of years. Macaulay duration is calculated by dividing the present value (PV) of annual cash flow (CF), including maturity payment, by the PV of total CF to obtain an annual CF percentage. Next, the annual percentages are multiplied by the time until payment or year number in which they occur (1, 2, 3, etc.), to obtain annual weighted figures. Finally, the annual weights are totaled to arrive at the Macaulay duration figure. The Macaulay duration formula can be expressed as follows: PVCF t = Present Value (PV) of the Cash Flow (CF) in period t discounted using current market discount rates t = the period in which the CF is received n = the number of years to maturity PVTCF = Present Value Total Cash Flow, including maturity value in the final year Macaulay Duration = (1)PVCF 1 + (2)PVCF 2 + (3)PVCF 3 +. (n)pvcf t PVTCF By comparing the WAT of one bond versus another, an investor could assess relative price sensitivity to interest-rate changes. Even better, by multiplying the WAT of a bond by a projected percentage change in market interest rates, a rough figure of the expected percentage price change in the bond could be found. In more recent times, the Macaulay duration formula has been generally replaced by a more useful measure known as modified duration. To understand the concept of modified duration, it is important to understand the foundation (and flaws) of Macaulay duration. The WAT of a bond, or a bond

2 FEATURE EXAMINING VOLATILITY IN FIXED-INCOME PORTFOLIOS portfolio, reflects how soon an investor will recover an investment in the form of coupon and maturity payments. It specifically takes into consideration that a highcoupon bond will provide a faster return of capital than a low-coupon bond. Visualizing Duration Interestingly enough, the modified duration product is actually the length of time that it will take for an investor to recover one-half of the PV of the initial investment. This can be illustrated visually by imagining a fulcrum balance scale (see figure 1). On the right side of the scale is the entire amount of the bond s remaining future payments (including maturity value), represented by a stack of dollar bills. On the left side of the scale are the dollar bills representing the payments that have been received to date. As the bond moves toward maturity, imagine that money is taken from the right side and placed on the left side. The point at which the scale has equal weightings will be the modified duration value expressed in years. This, for example, helps conceptualize why zero coupon bonds have a duration equal to their remaining maturity term they make no payments to the left side of the scale until the moment they mature. FIGURE 1: VISUALIZING DURATION C Timeline 0 1 Potential Choices during Rising Rates With the anticipation that interest rates are rising from record-low levels, many portfolio managers predictably are shifting investments toward lower-duration bonds. In addition, a number of advisors are emphasizing various asset classes and subsectors that they expect may outperform in a rising-rate environment. The question of where and how to position client assets Maturity date Duration TABLE 1: FIXED NCOME RETURNS IN RISING ATE ENVIRONMENTS Sector Description Average Quarterly Return (%) in Rising-Rate Quarters, Convertible Bonds 3.97 U.S. Corporate High Yield 2.50 Emerging Market Bonds 2.33 Preferred Stock Fixed Rate 1.53 Asset-Backed Floating-Rate Securities 1.28* U.S. Treasury TIPS 0.62** U.S. Intermediate Corporate 0.53 U.S. Mortgage-Backed Securities 0.40 Municipal Intermediate 5 10 Year 0.19 U.S. Aggregate Bond 0.07 Global Aggregate Bond 0.05 U.S. Treasury 3 5 Year 0.21 U.S. Treasury * Since December 31, 1996 Rule of thumb: Multiply duration by the change in market interest rates to determine the approximate change in market value. For more information on advanced bond portfolio construction methods, search such topics as modified duration, bond portfolio immunization, and bond convexity ** Since March 31, 1997 Source: Morningstar Director (2013) during rising rates has been the subject of much discussion and study by some of the best minds in the investment and academic communities. While past performance is never a guarantee of future results, table 1 depicts the returns of various sectors in the fixed-income market during quarters where rates have gone up. Although there appears to be an academic foundation for these results, it must be cautioned that the sectors that held up best during these periods may not fare as well in current and future periods of rising rates. Convertible Bonds Convertible bonds are hybrid securities that combine characteristics of bonds and stocks and provide investors with an alter- native to holding one versus the other. Because most convertibles pay interest, they can be impacted by interest-rate changes. However, the conversion opportunity (usually into common stock of the issuer) historically has made them less volatile during rising-rate periods. This generally has been the case when underlying stock prices also have appreciated or remained stable. The potential volatility-dampening benefit of the conversion feature can be explained by examining economic premises that may accompany a rising- rate environment: First, an increase in interest rates is often closely associated with actual or perceived inflationary concerns. These same concerns can manifest in a variety of data used to INVESTMENTS&WEALTH MONITOR

3 FEATURE EXAMINING VOLATILITY IN FIXED-INCOME PORTFOLIOS indicate expanding economic activity, such as lower unemployment, increasing nonfarm payroll rosters, higher plant capacity and utilization, rising gross domestic product, etc. Next, an expanding business environment can mean that providers of goods and services will see increases in areas including sales growth, revenue growth, profit growth, or simply cash flow. These increases often accompany or precede an increase in share prices, which in turn can increase the value of the conversion feature. As a result, when rising rates are accompanied by improvements in the overall business environment, a higher stock price can help convertible bonds fight back against the impact of rate increases. A second benefit of a rising-rate economic expansion (besides rising share prices) can be an improved corporate credit quality. An expanding business environment makes it easier for the typical company to repay its debt. This can then lead to a higher credit rating, which then makes the bond comparatively more valuable. Because most convertible bonds are issued by mid-sized companies without investment-grade ratings, improvements in the credit quality (or not) are realistic opportunities (or concerns). 1 Although convertible bonds have tended to weather rising-rate periods, they still face pricing pressures, and rate increases should be viewed as a real risk to convertible bonds. Other risks can include the potential lack of liquidity due to the smaller size of the convertible market, and expected sensitivity to events impacting the issuer, industry, and economy. High-Yield Bonds With the second-best results in our research, high-yield bonds also can benefit from credit-quality improvements in an expanding or inflationary economy. Academically, the higher coupons lower their duration, and many also boast premium pricing above their maturity values. In periods of economic expansion, improved financial results, or credit upgrades, high-yield bonds can be an option to consider versus high quality. In the broader markets, less-astute investors often misuse the term junk as a synonym for any bond that does not carry an investment-grade rating. This mistaken perception classifies high-yield bonds as junk bonds and can even apply to nonrated bonds regardless of the issuer s financial strength. In the financial industry, we often use the term junk bonds to refer to troubled company debt and to distinguish that category from other higher quality, noninvestment-grade bonds. In reality, there are multiple credit-quality ratings, including those that are just below investment grade. The typical concern for high-yield bonds is, of course, the risk of default. During the current, historically low, default environment, investors are well-advised to focus on actual default rates and not mere terminology. It is also of key importance to recognize that the bond market and credit-rating companies have a broader definition of high yield, which effectively applies to everything that is not strictly investment grade. This captures a broad range of credit quality, some of which may represent bond issuers with a precarious ability to make good on debts, and others which may represent corporate business models that, although successful, simply are not designed to operate with the requisite balance sheets needed to qualify for investment-grade ratings. Similar to the used car market, there is a combination of stand-out values and clunkers. It takes an expert credit analyst (often a team of analysts) to distinguish among the myriad choices. Today, the effectiveness of credit-quality research can be seen easily in the default rates between the overall highyield market versus carefully selected and managed portfolios (Brown 2013). In an expanding economy accompanied by rising interest rates, a carefully diversified and well-monitored high-yield bond portfolio can be one of the most liquid and profitable of all bond strategies. That said, it also should be recognized that high-yield bonds are often considered equity surrogates, and that their results historically correlate with the fortunes and trials of the underlying issuer. These bonds may have speculative characteristics and present significant risks beyond those of other securities, including greater credit risk and price volatility in the secondary market. Investors should be careful to consider these risks alongside their individual circumstances, objectives, and risk tolerance before investing in high-yield bonds. Emerging-Market Bonds Close behind high-yield in the historical performance results is the emergingmarkets (EM) bond sector. As with highyield bonds, EM bonds tend to be somewhat more credit sensitive and correlated with the underlying issuers success or failure. In addition to simple credit and business- model risk, EM bonds also may be impacted by the economic, currency, and political stability of the underlying country of origin. In past years, many EM bonds have offered higher yields than those of developedmarket bonds. Lately, the improving financial strength and credit ratings of many EM issuers has helped to narrow that advantage. It must be recognized that, although considered by many as an opportunity to potentially reduce overall bond risk through diversification, EM (and developed-market) bonds are subject to interest rate, political, currency, country, liquidity, and economic risks that may not be present in domestic bonds. Many advisors view emergingmarket and developed-market bonds as a permanent part of a portfolio, but other advisors consider them to be opportunistic trading vehicles where risk and reward must be carefully gauged. Emerging-market debt should make up only a limited portion of a balanced portfolio. Floating-Rate Bonds Near the middle of our historic returns for the period are bonds that do not have fixed interest rates. Available for decades, floatingrate or adjustable-rate securities (including bank loans) and their cousins, the U.S. Treasury inflation-protected securities (TIPS), recently have been getting much more advisor and investor attention. These bonds allow investors to trade a guaranteed yield-to-maturity in exchange for potential protection in certain economic environ- JANUARY/FEBRUARY

4 FEATURE EXAMINING VOLATILITY IN FIXED-INCOME PORTFOLIOS ments. Floating-rate securities may increase in yield as rates rise but, conversely, may decrease in yield when rates decline. TIPS yields are fixed, but they also offer a maturity value principal increase (only) if prespecified inflation rates are realized. The adjustable-rate feature can mean that, in a rising-rate environment, investors are not stuck with below-market interest rates. In turn, it is expected that these bonds will maintain a more stable market value and can be attractive to investors who wish to potentially reduce their interest-rate risk. Although duration of the typical floatingrate bond is very low and implies negligible interest-rate risk, these securities should never be confused with or thought of as money market funds. While the rates are geared to adjust with prevailing market conditions, these bonds generally have rate floors that limit how low their rates may go regardless of market conditions. In the case of floating-rate bonds that were issued during periods of higher interest rates, it is possible that market rates are below their floors. As a result, market rates may rise without a corresponding increase in the bond interest rate at least until the floor is reached and exceeded. Floating-rate bonds have other possible risks that should be recognized. Credit risk or default risk is associated with all bonds. Although not guaranteed by anyone other than the corporate issuer, floating-rate bonds are frequently senior collateralized loans, often from the same companies that issue the typical high-yield, fixed-rate bonds. As such, they tend to have higher credit quality and pay lower interest rates as compared to other high-yield bonds of the same issuer. Similar to the liquidity risk found in EM bonds, in the event of a broad market sell-off it may be difficult or impossible to match buyers with sellers. This can result in a significant and rapid drop in current market values even though final maturity values may be unchanged. Issued by the U.S. Treasury, TIPS do not have significant credit risk and historically have avoided liquidity problems. They generally pay a fairly low fixed-interest rate, but based on the level of inflation, TIPS may provide increased principal payments at maturity. As a result, TIPS are bought by investors who expect them to hold up relatively well in a rising-rate environment accompanied by increasing inflation. The expectation is that inflation is frequently a trigger for higher interest rates. However, if rates spike without an increase in inflation, as we have been experiencing recently, TIPS may lose market value in much the same manner as longer-term Treasury bonds. This has recently been the experience for TIPS and other Treasury bonds. Duration Traps As expected, rising-rate environments have hurt the longest-duration and highest creditquality issues the most. This means that U.S. Treasury and other government bonds, a mix that dominates the global aggregate sector, have lost comparatively more value than high-yield or floating-rate bonds. From a duration perspective, Treasuries are perhaps the most vulnerable. Because Treasuries are considered the U.S. benchmark by which other fixed-income securities are measured, they tend to have lower interest rates (lower coupons), and lower-coupon bonds have higher durations relative to higher-coupon bonds. As a result of Treasuries longer durations, they tend to be more volatile relative to other types of bonds in rising-rate environments. To help protect against rising rates, be especially wary of the highest credit-quality bonds and emphasize shorter maturities and lower durations. In addition, don t automatically eschew larger coupons because they carry a premium. In fact, non-callable premium bonds (above par) can offer some of the best hidden values in the bond market, both for their yield to maturity and comparatively lower duration and price volatility. Practical Value Fiduciaries and trustees generally are required to fulfill their investment duties with a higher standard of care than the general public. These higher standards translate into greater responsibilities and greater potential liabilities for breaches. Fiduciaries may be found liable for acts and omissions that may not be considered actionable for a non-fiduciary. In cases where the fiduciary may have difficulty satisfying investment requirements, these standards can be met and liabilities mitigated by the proper selection of an expert. The actual standard can depend upon the nature of the fiduciary relationship and, in some cases, the acumen, experience, and facilities of the fiduciary. For example, perhaps the highest standard is that of the prudent expert required by The Employee Retirement Income Security Act of 1974 (ERISA). ERISA Section 404(a)(1)(B) provides that fiduciaries must act with the care, skill, prudence and diligence under the circumstances then prevailing that a prudent person acting in a like capacity and familiar with such matters (emphasis added) would use in the conduct of an enterprise of a like character with like aims. Case law has widely held the capacity and familiarity requirements to mean that ERISA fiduciaries must function at or near the level of an experienced investment advisor. While the courts have applied this rigorous standard in non-erisa fiduciary cases, it is not mirrored in the Uniform Prudent Investor Act (UPIA), now adopted in most states. The prudent investor rule differs from the prudent expert standard and requires only reasonable care, skill, and caution, and the legislative notes indicate the intent to allow individuals of ordinary intelligence and experience to serve as trustees. As is characteristic in other areas of tort law, trustees possessing greater skill than individuals of ordinary intelligence are held to that higher skill level. As a result, if a trustee solicits employment by representing that it has greater ability than that of a mere prudent investor, the trustee must make reasonably diligent use of such ability. Third-party advisors, properly selected and responsibly monitored, can help fiduciaries 4 INVESTMENTS&WEALTH MONITOR

5 meet required levels of care, skill, prudence and diligence. Even still, the bottom line in many cases is that a fiduciary responsible for day-to-day decisions likely will need and certainly want to be familiar with investment theory and practice beyond that of the average person. The Restatement (Third) of Trusts, Section 77(2) contemplates that certain duties might require knowledge and experience greater than that of an individual of ordinary intelligence, depending on the investment strategy to be employed. The Restatement explicitly states that these circumstances do not prevent an individual of ordinary intelligence from serving but warns that these circumstances might impose a duty to obtain sufficient assistance. David J. Gordon, CFP, CIMA, is an executive director financial advisor and senior portfolio manager with Morgan Stanley in Deerfield, IL, where he specializes in fee-based portfolio management and comprehensive financial planning. A former practicing attorney ( ), he has authored textbook chapters on fixed income and on ethics. Contact him at david.j.gordon@morganstanley.com. Endnote 1. Based on Morningstar Principia Convertible Securities Category 9/30/13, used to substantiate credit quality and company size representation. Reference Brown, Janet Five Reasons Bond Funds Are Better Than ETFs. Forbes.com (March 7). com/sites/investor/2013/03/07/five-reasons-bondfunds-are-better-than-etfs/. This article originally was published in the January/February 2014 issue of IMCA s Investments & Wealth Monitor. Updated 7/2016. Morgan Stanley Smith Barney LLC ( Morgan Stanley ), its affiliates and Morgan Stanley Financial Advisors or Private Wealth Advisors do not provide tax or legal advice. This material was not intended or written to be used, and it cannot be used, for the purpose of avoiding tax penalties that may be imposed on the taxpayer. Clients should consult their tax advisor for matters involving taxation and tax planning and their attorney for matters involving trust and estate planning and other legal matters. The Portfolio Management program is described in the applicable Morgan Stanley ADV Part 2, available at ADV or from your Financial Advisor. The views expressed herein are those of the author and may not necessarily reflect the views of Morgan Stanley Smith Barney LLC. Material in this presentation has been obtained from sources that we believe to be reliable, but we do not guarantee its accuracy, completeness or timeliness Morgan Stanley Smith Barney Member SIPC CRC IMCA and INVESTMENT MANAGEMENT CONSULTANTS ASSOCIATION are registered trademarks of Investment Management Consultants Association Inc. CIMA, CERTIFIED INVESTMENT MANAGEMENT ANALYST, CIMC, CPWA, and CERTIFIED PRIVATE WEALTH ADVISOR are registered certification marks of Investment Management Consultants Association Inc. Investment Management Consultants Association Inc. does not discriminate in educational opportunities or practices on the basis of race, color, religion, gender, national origin, age, disability, or any other characteristic protected by law Investment Management Consultants Association Inc. All rights reserved. Reprint only with the permission of Investment Management Consultants Association Inc. Published by Investment Management Consultants Association Inc DTC PARKWAY SUITE 500 GREENWOOD VILLAGE, CO