PMC Weekly Review - November 20, 2015
A Macro View – Crying Wolf Over Rising Interest Rates
As we enter the last few weeks of 2015, the sense of déjà vu for economists, portfolio managers, and analysts focused on the domestic fixed income markets must be overwhelming. Starting about this time in 2009, the forecast for the next calendar year was for modestly stronger economic growth and the near certainty that the Fed finally would increase short term interest rates. Yet each succeeding year, growth was muted, if not flat, and the Fed stood pat, but the consensus was that next year would be the year. And here we sit, roughly a month before the final Fed meeting of 2015, with Fed Funds still effectively at 0% and only the possibility of a rate hike. Not only are short rates unchanged, but the 10-year Treasury yield has fallen from 3.88% at the end of 2009 to 2.30% today, and 2013 was the single year in which the 10-year yield ended the year higher than it began. A similar pattern holds for the 30-year Treasury, though it most likely will end 2015 with a yield that is higher than the 2.75% with which it began the year.
One might think after six consecutive years of “crying wolf” and being wrong, the outlook and behavior for both professional and retail investors would change. But once again, the consensus is for modestly better growth and at least one rate hike in 2016, whether or not the December hike is realized. And investors of all types continue to clamor for shorter maturity investments to protect them from the “wolf” of rising rates. From the beginning of 2009 through the end of the third quarter, investors have pushed $225 billion into short taxable and municipal mutual funds, increasing AUM in those categories by 3.7x and 3.0x, respectively1. By comparison, intermediate taxable and municipal funds added $350 billion in new assets, but both categories grew by just 2.2x. The “x-factor” is the massive growth in the non-traditional category, which ended 2008 with just under $9 billion in total net assets, but now represents $145 billion (after peaking at $160 billion)—an increase of 16.0x. These funds often have little or even negative duration, and use complex, hedge fund like strategies to create returns. Only slightly more than one-quarter of the more than 120 funds in this space currently have a five-year history, and the median return of those that do is just 1.8%, as of the end of the third quarter. Compare that to the 3.1% return of the Barclays Aggregate Bond Index, or 2.4% return of the Barclays Intermediate Government Credit Bond Index, over the same period.
But what would be the “cost” of a series of rate increases over the next 12 months? That would depend heavily on the forecast of when and how many; however, in all but the most extreme scenarios, the cost appears to be rather nominal. At the high end, for example, if the Fed raised rates by a quarter point four times over 12 months, the Barclays Aggregate Bond Index, with a duration of slightly more than 5.5 years, would see a price decline of a little more than 5%, which would be partially offset by income of a little more than 2.5%, for a total loss of 2.50-2.75%2. This would come close to the worst calendar year return on the Index in the last 25 years: -2.92% in 1994, when the Fed hiked rates 2.5% in 12 months. A much more likely scenario would be just two Fed rate hikes in the next 12 months, in which case the Barclays Aggregate Bond Index would come close to breaking even (about a 2.5% price loss offset by the 2.5% income). Both of these estimates are simplistic and crude, and ignore any changes in spreads or outside influences such as a risk-off flight to Treasuries. They do illustrate, however, that the currently expected slow pace of increases in the Fed Funds rate (whenever it actually starts) may create sub-par returns in the major indices (and thus most active managers) in the short term, but they will cluster either side of break-even, rather than produce significant losses.
1 Morningstar Fund Flow Data as of 10/31/2015
2 A purely parallel shift in the yield curve would result in a price loss of 5.5%, ignoring the time effect. We have assumed a slight flattening of the yield curve. Income is estimated off the current YTW and increased slightly as coupon income rises with the rate increases
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