FIXED INCOME Redefining Risk in US Treasuries June 213 ManulifeAM.com
Redefining Risk in US Treasuries Despite a modest back-up in recent months, yields on US Treasury bonds are still trading at extraordinarily low levels. As the recovery in the US economy broadens, many investors are wondering whether yields can remain this low or whether this is a bond bubble that is about to burst. We examine the case for holding US Treasuries, consider what is driving the market and how the risks inherent in this market are changing. The risks of holding US Treasuries are rising It has always been true to say that the risks associated with holding any bond are asymmetrical, but within many bond markets the probability of loss has increased over recent years. The reasons for this are two-fold: rising government borrowing levels, caused to a great extent by the fallout from the financial crisis, are lowering the credit quality of some sovereign borrowers, increasing the risk of default; and falling bond yields have simultaneously lengthened durations and reduced bonds protective yield cushion. Credit quality is falling While Europe s debt problems are well known, US debt-to-gdp levels have also risen sharply since the start of the financial crisis, and are now approaching levels not seen since World War II (chart 1). As a result, the credit risk of US Treasuries is rising. In August 211, Standard & Poor s cut its AAA credit rating on long-term US debt, reflecting concerns about the government s budget deficit and rising debt burden. These concerns are still valid: the last-minute partial resolution of the fiscal cliff negotiations has only served to highlight the political indecision to resolve this worsening fiscal situation. Yet US Treasury yields have yet to react to this worsening credit risk and history shows (chart 1) there is little precedent in the US to estimate how fast or how soon rates will respond to higher debt positions. While it is impossible to predict when this will lead to higher rates, it does change the balance of risk inherent in US Treasuries, increasing the probability of loss. Chart 1: US debt-to-gdp levels have ballooned since the start of the financial crisis, but real yields have yet to react Debt/GDP 12 1 8 6 4 2 194 1942 1944 1946 1948 195 1952 1954 1956 1958 196 1962 1964 1966 1968 197 1972 1974 1976 1978 198 1982 1984 1986 1988 199 1992 1994 1996 1998 2 22 24 26 28 21 212 1 5-5 -1-15 -2 1 Yr Constant Maturity Real Yield Source: Bloomberg Debt/GDP 1 Year Constant Maturity Real Yield The US is not alone seeing its credit rating fall. Sovereign ratings have fallen, or are under threat of downgrade, across the developed world: France lost its AAA rating in 212, while the UK similarly lost its AAA rating early in 213. This is in stark contrast to developing nations, which in general are not burdened 2
by large levels of government borrowings, and are seeing their credit ratings rise. Indonesia, South Korea and Philippines, for example, have seen upgrades to their credit ratings. However, rising debt-to-gdp levels and falling credit ratings, in themselves, do not necessarily pose a risk to developed bond markets, especially for a country, such as the US, which has a reserve currency. Of greater concern would be a reduction in foreign demand for US debt. If China, for example, decided to focus more on its domestic market, or if Asian excess savings were invested, or spent, at an accelerated rate domestically, this could trigger a rise in bond yields, regardless of any movement in credit ratings. As bond yields fall, duration risk has also increased Another consequence of the decline in bond yields has been rising duration risk. As yields have fallen, the proportion of a bond s return attributable to income has fallen, reducing its income cushion and lengthening duration. This has increased bonds vulnerability to rising interest rates. At the end of 199, the average yield and duration of the 1-year US Treasury bond was 8.1% and 6.6 years, respectively. If yields rose by 1 basis points, a bondholder could still expect to receive a modest positive return as any capital depreciation would have been more than offset by coupon payments. In comparison, at the end of 212, the yield on the 1-year US Treasury bond was 1.75%, while its duration was 9.4 years. Under these conditions, a 1 basis point increase in yields would result in significantly more capital depreciation, which when off-set by significantly less income, results in a sizeable loss and negative total return. Chart 2: 1-year US Treasury bondholders have far more exposure to rising interest rates compared to 2 years ago 12 Month Horizon Return for a 1 bps Increase in Yield 1 8 6 4 2-2 -4-6 -8 1.78-1.83-7.16 Dec-9 Dec- Dec-12 Duration (Yrs) Yield to Worst (%) 12 Month Horizon Return (%) As yields have fallen, the proportion of a bond s return attributable to income has fallen, reducing its income cushion and lengthening duration. This has increased bonds vulnerability to rising interest rates. Source: Bloomberg Duration measures the sensitivity of the price of a fixed income investment to a change in interest rates. For example, if interest rates were to rise by 1% at all points across the yield curve, a bond with a duration of 5 years would experience an approximate 5% decline in price. Horizon return is an estimated total return on an investment over a given timeframe based on specific investment attributes and market environments. Higher duration risk is not a problem if rates are expected to stay low or decline further, but there are good reasons to believe that the period of exceptionally low interest rates is coming to a close, even if the timing for higher interest rates is uncertain. Interest rates are poised to rise, but the timing is uncertain US Treasury yields are being underpinned by very accommodative monetary policy. However, the recovery in the US economy is broadening out, as evidenced by improvements in the housing market and autos. Even the labor market is healing, albeit slowly (chart 3). At some point the Federal Reserve (Fed) will need to raise interest rates since such loose monetary policy will no longer be appropriate. The question is when, and in response to what signals? And how will the bond market react? 3
Chart 3: US employment levels are recovering, but are still below their pre-financial crisis levels Non-Farm Payrolls (Thousands) 14, 138, 136, 134, 132, 13, 128, Jan-6 Mar-6 May-6 Jul-6 Sep-6 Nov-6 Jan-7 Mar-7 May-7 Jul-7 Sep-7 Nov-7 Jan-8 Mar-8 May-8 Jul-8 Sep-8 Nov-8 Jan-9 Mar-9 May-9 Jul-9 Sep-9 Nov-9 Jan-1 Mar-1 May-1 Jul-1 Sep-1 Nov-1 Jan-11 Mar-11 May-11 Jul-11 Sep-11 Nov-11 Jan-12 Mar-12 May-12 Jul-12 Sep-12 Nov-12 12 1 8 6 4 2 US Unemployment Rate (%) Source: Bloomberg Non-Farm Payrolls US Unemployment The Fed has stated that it will keep interest rates low at least until the unemployment rate declines to 6.5%. However, it has not provided the same level of clarity about quantitative easing, giving no indication as to when they will stop easing or when they will go into reverse and start to shrink the balance sheet. Both of these factors will be crucial in determining the performance of US Treasuries, and the language the Fed uses is likely to be a key indicator for the bond market. However, the Fed s actions and public statements will be entirely conditional on actual macroeconomic developments. The faster unemployment falls, the sooner the Fed will raise short-term rates towards a more normal level. Meanwhile, inflation expectations should provide a good proxy for the perceived risk of economic overheating; the sooner inflation expectations start to rise, the sooner the Fed will start to unwind its bond purchase program. Bond yields will gradually trend higher if inflation is well-behaved, as long as unemployment remains high. However, any surprises in the rate of decline in unemployment, in actual reported inflation, in inflation expectations or in the Fed s own rhetoric have the potential to trigger intense reactions in bond prices and yields, leading to a sharp sell-off in bonds. Interest rates could also stay lower for longer than many expect That said, while many investors believe that it is only a matter of time before US interest rates start to rise, it is interesting to note that US Treasury yields have yet to increase by any significant degree. In part, this is due to quantitative easing, which is continuing to underpin bond yields (according to the latest data, the Fed holds a third of all Treasuries). However, there are some who still believe that the bull market in bonds is yet to end. The US recovery remains weak by historic standards, while the problems in the Eurozone have yet to be resolved and continue However, there are some who still believe that the bull market in bonds is yet to end. to cause uncertainty. Given the lack of meaningful inflationary pressures, and with inflation expectations remaining anchored at low levels, there seems little, if any, need for tighter monetary policy at present. Indeed, as many governments, especially in the West, struggle with balancing the conflicting needs of reducing their budget deficits with the desire to stimulate economic activity, there are good reasons to believe that they will continue to promote policies that result in negative real yields. Such policies, which are a form of financial repression, can be viewed as a more palatable solution to this dilemma than many other fiscal policy options, especially given the growing backlash against austerity measures in many countries within Europe for example. 4
US Treasuries still provide benefits, but at a higher cost Given the negative implications of owning US Treasuries discussed to this point, it is important to note that they still play a role today in efficient portfolio asset allocation via liquidity and as an off-set to equity risk. US Treasuries remain one of the most liquid assets globally, a useful attribute given that one of the consequences of the financial crisis has been a sharp reduction in liquidity levels within the fixed income universe, especially in credit. For example, the Federal Reserve Bank of New York estimates that dealer inventories in corporate bonds have fallen from a peak of $23 billion in mid-27 to levels nearer $5 billion today, as banks seek to lower their exposures and risks. For much of the credit market, therefore, this can mean wider bid-offer spreads and lower transaction volumes. As a result, for investors who wish to retain exposure to liquid assets within their portfolio, US Treasuries still offer some attractions. As well as adding liquidity to a portfolio, US Treasuries remain one of the best ways of hedging against the risks of falling equity markets. However, the cost of buying that protection has risen sharply in recent years and US Treasuries may find themselves in an environment where they are outperformed by alternative assets when rates do start to rise. Finding protection in other parts of the fixed income universe Our analysis of correlations within the fixed income universe shows that credit (especially high yield bonds), securitized debt (such as asset-backed and commercial mortgage-backed securities), global bonds (especially those from Asian issuers) and emerging market bonds have low correlations to US Treasuries, indicating that they should provide good diversification when rates start to rise. Table 1: Correlations to US Treasuries over the past 1 years Fixed Income Sectors Agency MBS Pass-Through Securities.83 Asset-Backed Securities.15 Commercial Mortgage-Backed Securities.11 US Investment Grade Corporates.51 US High Yield Corporates -.2 Bank Loans -.42 Convertibles -.27 Pan-European Bonds.53 Asian Bonds.16 Emerging Markets Debt ($-denominated).28 Emerging Markets Debt (local currency).3 Source: Barclays Capital US Agency MBS. Barclays Capital US ABS, Barclays Capital US CMBS, Barclays US Corporate Investment Grade, BofA Merrill Lynch High Yield Master II, Credit Suisse Leveraged Loan Index, BoA ML Convertible Bonds All Qualities Index, Barclays Capital Pan-Euro Aggregate Index, Barclays Capital Asian Pacific Aggregate, JP Morgan EMBI, JP Morgan GBI-EM Global. Instinctively the results shown by this analysis make sense: Higher interest rates are often accompanied by periods of stronger growth, which is generally good for credit fundamentals, particularly investment grade and high yield corporate bonds. In addition, this more sanguine backdrop will benefit convertibles, which are also influenced by equity valuations. The income cushion offered by higher yielding bonds helps to protect investors from capital loss when rates do start to rise. Emerging market debt (and many Asian bond markets, excluding Japan) offers exposure to economically diverse regions of the world, as well as the potential for currency appreciation through local currency bonds. Bank loans should also provide protection against higher rates since their coupons reset periodically and are linked to the level of interest rates; their income rises as interest rates rise. 5
However, the real test is whether these alternatives to US Treasuries have actually provided protection during past periods where rates have risen significantly over an extended period of time. To analyze this, we have considered the four occasions during the past 2 years when 1-year US Treasury yields have risen by 15 basis points or more over the course of at least 12 months. Details of these are shown in table 2. Chart 4: Periods of extended rising US Treasury yields 9 8 7 6 5 4 3 2 1 Period 1 Period 2 Period 3 Period 4 Dec-92 May-93 Oct-93 Mar-94 Aug-94 Jan-95 Jun-95 Nov-95 Apr-96 Sep-96 Feb-97 Jul-97 Dec-97 May-98 Oct-98 Mar-99 Aug-99 Jan- Jun- Nov- Apr-1 Sep-1 Feb-2 Jul-2 Dec-2 May-3 Oct-3 Mar-4 Aug-4 Jan-5 Jun-5 Nov-5 Apr-6 Sep-6 Feb-7 Jul-7 Dec-7 May-8 Oct-8 Mar-9 Aug-9 Jan-1 Jun-1 Nov-1 Apr-11 Sep-11 Feb-12 Jul-12 Dec-12 Source: Bloomberg For each of the four periods identified above, we then compared the performance of US Treasuries to the performance of other fixed income assets previously identified as having low correlations with US Treasuries (table 2). Table 2: Fixed income returns during periods of an extended rise in US Treasury yields Sep-93 to Nov-94 Annualized Summary Statistics: Sep-98 to Jan- Jun-3 to Jun-6 Jan-9 to Dec-9 Period #1 Period #2 Period #3 Period #4 US Treasuries -3.7-1.84.93-3.57 Mortgage-backed Securities -1.3 1.33 2.87 5.89 Asset-backed Securities.55 1.63 2.7 24.72 Commercial Mortgage-backed Securities 1.43 28.45 Investment Grade Credit -4.18-1.27 1.83 18.68 High Yield Credit 1.18 3.62 9.21 57.51 Bank Loans 11.34 4.92 6.66 44.88 Convertibles -2.9 41.5 7.21 45.63 Pan-European Bonds 3.38 7.66 Asian Bonds.3 2.73 Emerging Market Debt ($-denominated) 26.15 9.31 28.18 Emerging Market Debt (local Currency) 1.5 21.1 Cash 3.9 4.76 2.27.16 Source: Barclays Capital US Agency MBS. Barclays Capital US ABS, Barclays Capital US CMBS, Barclays US Corporate Investment Grade, BofA Merrill Lynch High Yield Master II, Credit Suisse Leveraged Loan Index, BoA ML Convertible Bonds All Qualities Index, Barclays Capital Pan-Euro Aggregate Index, Barclays Capital Asian Pacific Aggregate, JP Morgan EMBI, JP Morgan GBI-EM Global. Periods greater than 1 year are annualized. 6
While data for parts of the market is limited for some of the earlier periods of time, the analysis confirms that high yield bonds, leverage loans, convertibles and emerging market debt have recorded positive returns during times of rising rates, while the case for traditional securitized debt and high quality global bonds is less compelling. In conclusion US Treasuries continue to offer the benefits of liquidity and protection against falling equity markets. As such, they will continue to be a core holding within many diversified portfolios. However, falling yields and a worsening fiscal position mean the risks inherent in the market have risen, making the cost of buying portfolio protection substantially higher. Looking ahead, the rise in duration risk, in particular is of concern given that tighter US monetary policy is moving ever closer. Investors can help to offset these risks by broadening their fixed income holdings to include high yield bonds, bank loans and convertibles. These fixed income assets have low correlations with US Treasuries and often benefit from the economic conditions that necessitate higher interest rates. In addition, while long-term resolution to the US fiscal position seems unlikely given the political indecision over the fiscal cliff, emerging market debt also offers exposure to regions with diverse economic conditions. Many of these nations are not burdened by large levels of government debt carried by the developing world, and are seeing improving credit ratings. 7
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