Long-duration: Volatility in isolation, safety in context Blog

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1 17 December 2018, 10:06PM UTC Chief Investment Office GWM Investment Research Long-duration: Volatility in isolation, safety in context Blog In this month's House View letter, we closed our overweight to 10-year Treasuries, replacing this with a new "US Treasuries (long)" line item, whose benchmark will be a 20+ year Treasury Index. The main reason for making this change was to replace a tactical trade that we expected to work in our base case scenario of gradually rising yield (which succeeded) with a countercyclical position that is more of a hedge, providing more potent protection against equity downside risk but likely underperforming when stocks perform well. Below, we will look at these issues and consider them in the context of implementation. Implementation considerations Two of the longest duration US Treasury ETFs are the ishares 20+ Year Treasury Bond ETF (TLT) and the Vanguard Extended Duration Treasury ETF (EDV). TLT tracks our official 20+ year Treasuries benchmark, while EDV tracks an index of year US Treasury STRIPS, which are zero-coupon Treasury bonds. TLT has a duration of 17.3 years, and would therefore theoretically lose about 17.3% if interest rates jumped 1% overnight. Meanwhile, EDV has an even longer duration, at 24.3 years. In isolation, long-duration Treasuries sound pretty risky. But it's important to remember that interest rates usually rise when growth and inflation are picking up, which tends to be good for stocks. As a result, stocks' best years tend to be pretty bad for bonds, and the opposite is also true, as shown in Fig. 1. This report has been prepared by UBS Financial Services Inc. (UBS FS). Please see important disclaimers and disclosures at the end of the document. 01

2 Fig. 1: A great year for stocks is a tough year for bonds, and vice versa Index total returns, select time periods Source: UBS, Bloomberg, as of 14 December Note: 'US Gov't FI' refers to our 'US government bond' Strategic Asset Allocation line item, which currently has a 6-year duration. If we were highly confident that the bull market would see a drastic reacceleration of growth and inflation, we'd want to shy away from longduration Treasuries and adopt a more unequivocal risk-on position. But as the bull market is aging, longer-duration Treasuries are an increasingly useful portfolio hedge against the risk that economic growth might falter. That scenario is an especially large risk for more equity-heavy portfolios. That's why, for Moderately Aggressive and Aggressive portfolios where tactical allocations to fixed income are as low as 6% a more potent longduration Treasury implementation might be more effective for balancing portfolio risk. Fig. 2 demonstrates the additional 'crisis alpha' that a strategy like Treasury STRIPS might provide over longer-term bonds. Duration is a tool for risk management Long-duration Treasuries and STRIPS can exhibit high volatility on their own, but this high volatility is a bonus when it comes to a portfolio context because duration is a powerful tool for managing equity drawdown risk. Equity volatility and drawdowns are the largest source of risk in most portfolios; even in a 20% stock, 80% bond portfolio, stocks contribute more than 50% of the portfolio volatility and nearly all of the portfolio's downside risk. For very conservative, bond-heavy portfolios, adding a long-duration holding might marginally increase expected returns, but it will often increase portfolio volatility, too. But in equity-heavy portfolios, adding long-duration Treasuries will actually reduce portfolio volatility due to the 'diversification effect': stocks and zero-coupon bonds each exhibit high volatility, but the asset classes' 'zigs' and 'zags' offset one another, so portfolio volatility falls as the allocations fall into balance. Adding longduration Treasuries therefore provides a larger boost to risk-adjusted returns for equity-heavy portfolios. 02

3 Fig. 3 illustrates the last 20 years of returns for global stocks, alongside indexes for long-term Treasury bonds and STRIPS. We're not sure what the next bear market will look like. We're fairly confident that it won't be as pronounced as the Tech Bubble or the Global Financial Crisis, so equity losses should more closely resemble an average bear market loss of 20-30%. Similarly, we shouldn't expect interest rates to fall too far (though negative rates are a possibility, as demonstrated in Japan and Europe), which will limit the long-duration bonds' potential upside. Could stocks and bonds fall together? While stocks and bonds tend to move in opposite directions, this is not always the case. One risk would be a a "stagflationary" environment, where the Fed falls substantially behind the curve and we see inflation acceleration outpace nominal economic growth improvements. This would be a potential negative for both stocks and bonds, as the rapid increase in inflation would prompt the Fed to raise rates more aggressively. In the current environment, we agree with the Fed's assessment that this is an unlikely outcome, given the gradual pace of inflation improvement over the last several years. And it's also important to note that, since 1945, largecap stocks and Treasuries have fallen together in less than 1% of 12-month rolling returns, and never during an equity bear market drawdown. Conclusion In our base case scenario, these long-duration positions should deliver muted returns, underperforming the broader portfolio as interest rates rise again, while our overweight positions in global and EM stocks provide outsized returns as investors' risk appetite returns. But we re late enough in the economic cycle that it's prudent to begin protecting the portfolio against the risk that we're mistaken. For more implementation details, please see our Highlighted ETFs report published 17 December

4 Fig. 2: More duration means more cushion during equity sell-offs 6-month total returns for 20+year Treasuries, year STRIPS, during periods where global stocks fell Source: Bloomberg, UBS, as of 14 December 2018 Fig. 3: Stocks and bonds have little correlation over the long run, and can both rally over time Cumulative total returns since December 1998 Source: Bloomberg, UBS, as of 14 December 2018 Justin Waring, UBS Financial Services Inc. (UBS FS) David Perlman, UBS Financial Services Inc. (UBS FS) 04

5 Appendix Exchange Traded Funds (ETFs) Disclosure For purposes of this report, ETFs include index-linked funds regulated under the Investment Company Act of 1940 that trade on US securities exchanges under exemptive relief from the Securities and Exchange Commission. The shares of all of the ETF issuers discussed in this Report are listed on US securities exchanges. The ETFs are either open-end, registered investment companies (including UITs) operating under an exemptive order from the SEC, or collective investment vehicles, formed as grantor trusts, limited partnerships or similar structures that offer pass-through tax treatment to investors. The different structures provide different rights for investors. For example, ETFs registered under the Investment Company Act of 1940 must stand ready at all times to redeem shares (albeit only in creation unit size) whereas those ETFs that are not subject to registration under the Investment Company Act of 1940 may suspend redemptions at any time. We refer to ETFs registered with the SEC under the Investment Company Act of 1940 as 40 Act ETFs and to nonregistered ETFs as 33 Act ETFs. Most of the ETFs discussed in this Report track an index of financial instruments or provide exposure to a single commodity type. ETFs are subject to the same risks as the underlying securities and commissions may be charged on every trade, if applicable. This definition does not imply that ETFs are endorsed by the Securities and Exchange Commission. Any discussion contained herein regarding future performance is not intended to guarantee future performance or to suggest that past performance will reoccur. Moreover, target returns are not intended to be projections but to provide a range within which price levels may move assuming current market conditions as well as the other assumptions mentioned in the Report are met. Performance of an index is not illustrative of any particular investment. It is not possible to invest directly in an index. ETFs are sold by prospectus, which contains details about ETFs, including investment objectives, risks, charges and expenses. Clients should read the prospectus and consider this information carefully before investing. US-registered, openended index-linked funds are redeemable only in Creation Unit size aggregations through an Authorized Participant, and may not be individually redeemed. Many ETFs are redeemable only on an "in-kind" basis. The public trading price of a redeemable lot of ETFs may be different from their net asset value, and ETFs could trade at a premium or discount to the net asset value. 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