Since the initial shock of the global financial crisis forced central banks into taking dramatic action in 2008, high degrees of monetary accommodation have been part of the economic and investment landscape. The extent of Federal Reserve balance sheet expansion has been extraordinary, as has been the maintenance of low policy rate levels. In that context, a wide variety of asset classes have disconnected from their fundamental valuation underpinnings and it has become increasingly clear that Fed action is profoundly distorting U.S. fixed income markets.
As the Fed met on Dec. 11-12 to clarify and expand upon its policy goals and tools for its third round of (now open-end) quantitative easing, fixed-income investors would do well to consider the impact Fed policy is having on bond market supply/demand dynamics. Specifically, net supply across taxable fixed-income sectors will remain low, particularly when additional Fed purchases are accounted for. Yet the sheer demand for fixed income product and the relative lack of available supply is likely to have a powerful rebalancing effect on markets in 2013. Indeed, we already see major banking institutions reducing portfolios of “crowded-out” assets in favor of more productive uses of capital (such as commercial and industrial lending), a result that dovetails with the Fed's general intent.
Alongside this, however, are tangible changes taking place in gross fixed-income supply. Unlike net supply, gross fixed-income issuance numbers are relatively high and, intriguingly, this new issuance is coming with very long average durations (a measure of interest rate risk). With these lower coupons and longer maturities, the new issuance is adding a good deal of duration risk to the fixed-income market, while investors continue to flock to the perceived safety of bonds.
Monetary policy-induced distortions to fixed-income markets have a number of unintended consequences, but none is more relevant to investors today than the interest rate risk that has been introduced into many core fixed-income portfolios that maintain a close tie to the Barclays U.S. Aggregate index. Indeed, over the past several years we have witnessed a seemingly inexorable trend toward lower and lower coupon levels and increased duration.
Effectively, this dynamic is introducing an ironic element to broad fixed-income markets, in that investors have flooded bond markets with capital in search of safety, but they are increasingly being compensated less and less, and the risks they are taking have grown significantly. For this reason, we believe it is increasingly important for investors to become more flexible and opportunistic in their bond portfolio allocations and not merely accept generalized bond market exposure.
As to the risk of interest rates rising meaningfully in the near-term, we deem that probability low. Fed policy should keep rates in check for the time being. That said, if inflation were to rise even modestly, if the labor market were to improve more rapidly than expected, or if the eurozone debt crisis stabilized significantly — the pressure on monetary policy could ease, leading to a back up in risk-free rates. And fixed-income markets today are highly sensitive to rate movements. The duration embedded in the 30-year Treasury bond is near all-time highs, such that it would only take a 15 basis point increase in rate levels at the 30-year part of the yield curve to wipe out an entire year's worth of yield.
Additionally, daily price volatility in 30-year Treasuries was also relatively high in 2012, exceeding that of even the S&P 500 Index of large-cap equities. Moreover, with starting yield levels so low across the fixed-income universe (the 10-year Treasury currently yields 1.9%), and in fact in many cases running below the rate of inflation, even if interest rates were to decline in 2013, the potential upside in bond portfolios would not likely equal the returns seen in recent years.
The upshot for investors is both that they need to keep realistic expectations for total returns in fixed income over the next year, and that they should be wary of the increasing risk/reward asymmetry exhibited by the asset class today, which directly stems from our policy environment. Shifting capital to more flexible and opportunistic mandates is one important tool investors can use to help mitigate these concerns. Of course, effectively navigating bond markets has been a challenge since the onset of the financial crisis, but in the year ahead there will be little margin for error as yields have dwindled and some risks are magnified. That the year won't be dull is certainly one of the few things of which we can be sure.