The bull market in fixed income has been raging since Paul Volcker’s war on inflation took interest rates to more than 20% over three decades ago. Current Fed Chairman Ben Bernanke has taken the opposite tack — maintaining rates at close to zero since 2008. It doesn’t take a doctorate in economics to figure out that this long bull market in bonds might soon come to an end as central banks’ balance sheets balloon and the window for further monetary easing closes.
Even the Fed has felt the need to be more creative in the last few years to bring the long end of the yield curve down. Its policies, along with easing by central banks around the globe, have been more unconventional and more untested than at any other time in history. We are fast approaching the natural zero-boundary, where the law of diminishing marginal returns rears its ugly head.
To protect themselves, pension fund managers and other investors need to devise effective hedges for their fixed-income portfolios. Because timing is everything, chief investment officers should take the time to understand the high costs of investing in negative expected value, or “black swan” type tail-risk funds, and construct a safer more efficient approach that minimizes hedging costs, is less dependent on market timing and has a positive expected value.
In addition to central bank manipulation, the bull market in bonds has been fueled by massive outflows of money from the equity market into fixed-income portfolios due either to general risk aversion or an aging baby-boomer generation focused on generating income. Exacerbating this imbalance, risk parity portfolio models have significantly increased the demand for fixed-income securities. Even a downgrade of U.S. Treasuries by the ratings agencies last year led to a rally in bond prices as people pursued what they perceived as the best house in a bad neighborhood. Investors have rightfully been more concerned about protecting their capital rather than earning a return on it.
But the risk/reward profile for fixed-income investments has now deteriorated to such a point that their outperformance has taken us to the natural zero-bound wall. Duration, which has been the best friend of portfolio managers and asset allocators, may at this point become their nemesis.
If 1993-1994 is any precedent for how fast rates can spike, being long duration does not justify the risk. From the fall of 1993 through the winter of 1994, the 10-year rate spiked close to 300 basis points (5.16% to 8.02%) and the Fed Funds Rate increased from 3% to 5.5%. A move of just half this amount today would be devastating to asset managers and cause serious pain for pension funds and other institutions with large fixed-income portfolios.
Our view is that the biggest risk for global markets is not the European debt crisis — it is a sudden spike in interest rates and the resulting crash in bond prices. Any resulting decline in equities will likely be accompanied by a spike in credit spreads, which will further exacerbate the problem. Equity markets are being supported through the quantitative easing lifeline thrown by central banks explicitly targeting higher equity prices by decreasing the yields on alternatives.
This secular rally has contributed to numerous distortions in the market. In the U.S., investors are reaching for yield by investing in securities with much lower credit quality in the belief that the Fed will keep interest rates low until at least 2015 despite arguments against such measures, not to mention projections by members of the Federal Reserve Board. Mitt Romney has already stated publicly that he does not intend to renew Mr. Bernanke’s term, which will end on January 31, 2014. How then can Mr. Bernanke promise to keep rates low until the end of 2015 if there is a chance he won’t even be in office? On top of this, congressional lawmakers from the Tea Party have been pushing the Fed to cease its monetary easing.
Furthermore, central bank policies are already hurting consumers at the gas pump as well as at the grocery store. At some point in time, in the not so distant future, these policies will have to be reverted, and the central bank’s balance sheet returned to more manageable levels. Hiking interest rates, coupled with liquidation of levered fixed-income portfolios both of investors and central banks’ balance sheets, can cause a great disruption in the fixed-income markets. This disruption will be even greater if rates are hiked at a time when inflation expectations are rising.
However, all is not doomed. Portfolios can be hedged against unfavorable outcomes. The same unconventional measures that have created distortions in global yield curves globally offer opportunities to shorten duration while providing positive carry. The key is to find the right way to short duration in a convex way while not giving up yield.
Thanks to the intervention of interest rate curves globally by central banks, we have been presented with many opportunities to hedge against the possible spike in interest rates and possibly even profit from it. Should the bull market in bonds end, and it will at some point, those pension funds and other institutions that have properly and efficiently hedged this risk in their portfolios will be spared the pain. This can only be achieved by implementing and actively managing a tailored hedging program designed to achieve the particular needs of each investor.
Ari Bergmann is the managing principal of Penso Advisors LLC. Penso is an advisory and asset management firm that manages systemic risk portfolios for large pension funds, endowments and large hedge funds.
