Commentary March 2013

Transcription

1 Market Price of Bond Market Price of Bond Commentary March 2013 Interest Rates: Creeping Higher Interest rates and bond yields are at multi-generational lows and are expected to trend higher over the next few years. When they occur, SEI believes the rate hikes will be gradual, rather than sudden. Because our bond funds generally have shorter duration and higher yield characteristics than corresponding benchmarks, we believe they are relatively well-positioned for a moderately paced rise in interest rates. In recent years, central banks have kept interest rates low in an effort to support the struggling global economy. Despite the low rates, risk-averse investors have flocked into high-quality government bonds, largely to avoid the effects of the slow economy. The combination of central bank action and the economics of supply and demand have caused bond prices to rise. As a result, most bonds have performed well, following the pattern shown in Exhibit 1. Exhibit 1: Prices Rise as Yield Fall $1,400 $1,200 $800 $600 $400 $200 $- Calculations are for a hypothetical bond with face value, 10 years to maturity and a $50 annual coupon paid once per year. But today, with interest rates at multi-generational lows and a slow but steady economic recovery (stronger economic growth is typically associated with higher interest rates), many investors are concerned about rising interest rates and the negative effect they would have on bond values. The Massacre of 94 Bond price rises 5% 4% 3% 2% Falling market interest rates ====> Fed Chairman Bernanke is a student of history, and we re sure he ll remember the bond massacre of After several years of flat short-term interest rates, the Fed raised interest rates on February 4 that year. The 25- basis-point 1 increase was the first of six rate hikes totaling 250 basis points by year end. Long-term bonds fell almost 9% and stocks corrected by a similar amount. Swift and significant rate hikes would likely deal a similarly crushing blow to markets in Exhibit 2 highlights the inverse relationship between interest rates and bond prices. Exhibit 2: Bond Prices Fall as Rates Rise $1,200 $800 $600 $400 $200 $- Rising market interest rates ====> Calculations are for a hypothetical bond with face value, 10 years to maturity and a $50 annual coupon paid once per year. Our View Bond price falls 5% 6% 7% 8% In today s fixed-income markets, the 10-year Treasury bond is generally viewed as the benchmark issue in terms of judging the overall market. With it carrying a yield of only about 2%, SEI views the 10-year Treasury bond as clearly overvalued. Our analysis shows that a yield of at least 3% would be fair value relative to today s growth and inflation dynamics. Historically, Treasury yields have been fairly valued when they equal an expected inflation rate plus a real-rate premium that is dependent on economic conditions. The real-rate premium can be thought of as the true cost of debt. Treasury Inflation 1 One basis point equal 0.01% SEI 1

2 Protected Securities 2 are a reasonable barometer for inflation expectations and they have recently implied a 2.25% to 2.50% inflation rate. If the economy were healthy, we would expect a real-rate premium to result in a nominal yield in the neighborhood of 4%; however, given the current weakness, we would expect a risk premium of only 1% based on historic norms, which is how we derive our fair-value estimate of at least a 3% nominal yield. Because SEI hires a significant number of asset managers from across a broad swath of the industry to oversee assets in our Funds, we have access to the research and insight these managers rely on when making investment decisions. During our ongoing due diligence meetings, we discuss interest rates with these managers, and we recognize that some of them expect prices to fall even more than we do. At the far end of the spectrum, Metropolitan West Asset Management, an investment-grade intermediate fixed-income manager, believes a 4% yield would represent fair value. While we and the managers we work with see rising rates as inevitable, we do not expect them to spike with a bursting of a pricing bubble. Instead, with major central banks around the world continuing to pump liquidity into the markets by holding interest rates low and implementing a variety of quantitative easing programs, we believe the increase will occur slowly. A likely scenario would be a modest increase of perhaps 0.25% to 0.50% by the end of this year, and of course this increase could be pushed out even further. This will more likely be the result of a larger real-rate premium rather than an explicit increase in inflation expectations. We expect an evolution, not a revolution, as the Fed will begin tapering off its asset purchases rather than putting a swift end to quantitative easing. We could actually see the Fed start to slow its purchases this year, which could put some modest upward pressure on interest rates. Many investors seem to be hanging onto past Fed statements that interest rates would remain low into mid or that they would not rise until unemployment improves or inflation picks up. But when those data points improve, it will indicate a more robust economy. If the Fed does not taper purchases in advance of changes in the economic data, it could be forced to increase rates rapidly. Given current economic weakness and the upward pressure that rapidly rising rates would put on mortgages (potentially crushing the nascent housing rally) we just can t see the Fed initiating a major rate increase in These securities are indexed to inflation in order to protect investors from inflation. They are backed by the U.S. government and their par value rises with inflation, as measured by the Consumer Price Index, while their interest rate remains fixed. In part because of our interest-rate view, SEI fixedincome portfolios have a modest short-duration 3 position. This is a view shared by most of our sub-advisors. However, Jennison Associates, an investment-grade intermediate fixed-income manager, is overweight the 30- year Treasury bond. Since we do not agree with this view, we have underweighted Jennison in the portfolio. We did not eliminate Jennison, but rather we acknowledged their contrarian position, as it serves as diversification and a hedge in case rates rise more slowly than expected or if we see an unexpected rate decline. This acceptance of contrarian positions is an important part of SEI s portfolio construction process. While we may have clear indications of the future direction of the markets, and the majority of the investment managers we work with may hold the same perspective, we believe investors should be worried when every holding in their portfolios is positioned for the same market outcome. Such positioning may be beneficial if everything works out as planned, but it can be devastating if the unexpected occurs. For this reason, we are quite willing to give up a small percentage of the potential upside benefit in order to obtain a measure of downside protection. This conscious positioning aligns well with our objective of delivering more consistent results, rather than chasing performance at all costs. A Little Bond Math Exhibit 3 illustrates the relationship between price and yield for a hypothetical 10-year bond with a maturity value of and coupon rate of 2%. As you can see, when the bond s yield is 2% the price is equal to the maturity value. When interest rates decline, the bond become more valuable. Conversely, if interest rates increase the bond will decline in value. For a 25-basispoint rate increase, using standard textbook valuation calculations, the price of the bond would be expected to fall to approximately $977.83, a 2.22% 4 decline in value or $22.17 in monetary terms. Note that the percentage decline in value is significantly more than the change in rates was. However, the price decline will also be at least partially offset by the coupon payments. In the first year, the bond will pay a $20 coupon, so the total expected return would be a 0.22% decline or only a loss of $ Duration is a commonly used and sometimes misunderstood bond characteristic. Duration is expressed in years and it estimates the sensitivity of a bond s price for a given change in interest rates. Bonds with shorter duration will experience a smaller change in price than bonds with a longer duration. Duration can also be thought of as a measure of interest rate risk, with longer-duration bonds having more risk to interest rate changes. 4 Note that return calculations do not take taxes into account and certain elements of these returns may be treated differently for tax purposes SEI 2

3 Expected Total Return Bond Price Exhibit 3: Price and Interest Rates $1,120 $1,100 $1,080 $1,060 $1,040 $1,020 $980 $960 $940 $920 $ % 1.50% 2.00% 2.50% 3.00% Hypothetical 10-Year, 2%,, annual pay bond If we extrapolate that out to a 1% rate increase, the price of that bond would be expected to fall to $914.70, an 8.53% decline in value or $85.30 in monetary terms. Looking at numbers on this scale, it is easy to understand investors fears. Just as in the previous example, the price decline will also be at least partially offset by the coupon payments. In the first year, the bond will pay a $20 coupon, so the total expected return would be a 6.53% decline or only a loss of $ Don t Stress the Test Interest Rate Actual performance may not be quite as bad as our previous calculations indicate. To assist in our evaluation of the potential impact of an interest-rate hike, our Risk Management team performed a stress test 5 using 25-, 50- and 100-basis-point rate increases across several benchmark bond indices used by SEI Funds. The results of the stress test are shown in Exhibit 4 at right and reveal expected declines for investment-grade fixed income indices, while high-yield and emerging-markets debt (EMD) are expected to generate positive total returns. This pattern of expected performance should not be surprising as it closely resembles performance in prior periods of slowly rising interest rates. Also as expected, the portfolios that generate a higher amount of current income (high-yield and EMD) are better positioned to offset the price declines. What Does This Mean for SEI Funds? What is most important to investors is how does this impact the SEI Funds that they own? Given that SEI Funds in general have higher yields (to help offset the price declines) and shorter duration (to help mute the price declines) than their benchmarks, we would generally expect our Funds to modestly outperform in an environment where interest rates are gradually rising. Some investors will certainly wonder why they should even hold bonds when we expect low or possibly even negative short-term returns. While bond returns could be meager, the decision to hold them should be based on an investor s objectives, not on short-term market expectations. Fixed-income investments can and do play a role in a variety of investment strategies and will continue to do so regardless of the direction interest rates move. Fixed-income markets continue to offer more attractive income-producing opportunities, while Treasury securities provide an attractive hedge to more aggressive portions of investors portfolios. Furthermore, diversification is as simple as it is powerful spreading a portfolio among a variety of investments can result in a more consistent pattern of returns and income. Exhibit 4: Expected Returns After Rates Rise 2.00% 1.00% 0.00% -1.00% -2.00% -3.00% -4.00% Source: BlackRock Green Model Our Outlook +25 bps +50 bps +100 bps Assumed Change in Interest Rates Barclays US Aggregate Index BofA ML US High Yield Constrained Index 50% JP Morgan EMBI Global Diversified Index / 50% JP Morgan GBI-EM Global Diversified Index Barclays Global Aggregate Index We don t expect to see dramatic rate increases, nor do we foresee a massive bond-market selloff. Accordingly, SEI s fixed-income funds have been positioned for a moderate rising-rate environment. While there will likely be some pain, we expect this positioning to help the funds weather the bond-price declines that typically accompany interest- rate increases. 5 A stress test is a simulated what if exercise performed in an effort to gauge the results on an investment in a given hypothetical scenario. Please see the last page of this document for a brief general discussion of the risks and limitations of stress testing SEI 3

4 Index Definitions The Barclays U.S. Aggregate Bond Index is an unmanaged benchmark index composed of U.S. securities in Treasury, Government-Related, Corporate, and Securitized sectors. It includes 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 $250 million. The BofA Merrill Lynch US High Yield Constrained Index measures the performance of high yield bonds. The JP Morgan Emerging Market Bond Index is a total return, unmanaged trade-weighted index for U.S. -dollardenominated emerging-market bonds, including sovereign debt, quasi-sovereign debt, Brady bonds, loans and Eurobonds. The JPMorgan EMBI Global Diversified Index tracks the performance of external debt instruments (including U.S.- dollar-denominated and other external-currency-denominated Brady bonds, loans, Eurobonds and local market instruments) in the emerging markets. The Barclays Global Aggregate Bond Index is an unmanaged market-capitalization-weighted benchmark that tracks the performance of investment-grade fixed- income securities denominated in 13 currencies. The index reflects reinvestment of all distributions and changes in market prices. More Information on Index Stress Testing While stress testing is designed to test the effects on an investment by analyzing what may happen to the investment if particularly adverse and unexpected events would occur, there is no guarantee that future events would produce similar results. There is no guarantee that these events will materialize and, if they do, that they will have the effect indicated in the stress test. Stress tests results were generated using the BlackRock Solutions Portfolio Risk Tools. Assumptions are entered and the Portfolio Risk Tool uses its factor model to impute shocks for the rest of the factors based on these assumptions. The test results discussed in this piece used data as of 2/26/13. Tests run using different data points may yield different results. Assumptions used: 10-year U.S. Treasury rates rose by 25, 50 and 100 basis points. There are risks and limitations inherent in stress tests. Past relationships may not hold in the future or, if they do, may produce materially different results. There may be limitations on a particular risk model s capabilities such that the inputs are insufficient to capture the effects of an occurrence on a particular investment. This risk may be particularly acute if few assumptions or inputs are utilized SEI 4

5 This material represents an assessment of the market environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice regarding the Funds or any stock in particular, nor should it be construed as a recommendation to purchase or sell a security, including futures contracts. There is no assurance as of the date of this material that the securities mentioned remain in or out of SEI Funds. For those SEI Funds which employ the manager of managers structure, SEI Investments Management Corporation (SIMC) has ultimate responsibility for the investment performance of the Funds due to its responsibility to oversee the sub-advisers and recommend their hiring, termination and replacement. SIMC is the adviser to the SEI Funds, which are distributed by SEI Investments Distribution Co. (SIDCO). SIMC and SIDCO are wholly owned subsidiaries of SEI Investments Company. To determine if the Funds are an appropriate investment for you, carefully consider the investment objectives, risk factors and charges and expenses before investing. This and other information can be found in the Funds prospectuses, which can be obtained by calling DIAL-SEI. Read them carefully before investing. There are risks involved with investing, including loss of principal. Current and future portfolio holdings are subject to risks as well. International investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles or from economic or political instability in other nations. Emerging markets involve heightened risks related to the same factors as well as increased volatility and lower trading volume. Bonds and bond funds will decrease in value as interest rates rise. High-yield bonds involve greater risks of default or downgrade and are more volatile than investment-grade securities, due to the speculative nature of their investments. Diversification may not protect against market risk. There is no assurance the objectives discussed will be met. Past performance does not guarantee future results Index returns are for illustrative purposes only and do not represent actual portfolio performance. Index returns do not reflect any management fees, transaction costs or expenses. One cannot invest directly in an index. Not FDIC Insured No Bank Guarantee May Lose Value 2013 SEI 5