Since the fall of 1981, we have seen long-term U.S. Treasury yields fall to 6% from 15%. Rates recently have rebounded to 7.5% in a vicious market sell-off. Bond portfolio managers are faced with the challenge of operating in a less friendly environment than that of the past 13 years. If inflation remains moderate for the balance of the 1990s, the "easy money" days of double-digit returns on bonds may be over.
Plan sponsors, consultants and their constituents are interested in understanding how the bond component of their retirement plan can be expected to perform in such a radically different investment climate for bonds. Fortunately, there are many strategies that an active bond manager can employ in order to operate successfully in this new environment.
Value of yield
In a low-yield environment, incremental yield has more value than in a high-yield environment. An extra 50 basis points of yield shows up more prominently in a 7% interest-rate environment than in a 15% interest-rate environment. A corporate bond that yields "only" 50 basis points over a comparable U.S. Treasury may not look appetizing on a historical basis, but in the yield environment we have today, it may be an attractive alternative to Treasuries.
The steeply positive yield curve that now exists allows one to pick up substantial chunks of yield for modest maturity extensions (based on April 5 data): 1s to 2s (70 basis points), 2s to 4s (80BP), 5s to 10s (50BP), and 10s to 15s (35BP). The international bond market and the below-investment-grade corporate bond market also present opportunities for adding yield to a traditional, domestic bond portfolio.
Current yield, a measure of a bond's coupon income as a percentage of the bond's market price, is in demand these days. High-coupon bonds, which offer abnormally large amounts of current yield, are a disappearing breed thanks to refinancings and maturing issues. Bond mutual funds, a growing influence in the bond market, pay their dividends and expenses out of current income. Bond mutual funds also use current yield as a selling tool and maintain higher-than-market payouts to retain shareholders. As a result, the demand for bonds with high current yields is likely to remain strong, and these issues will remain well bid in the marketplace.
Value of rolldown
A positively sloped yield curve is an engine for incremental return. The engine is fueled by yield curve rolldown.
Rolldown occurs as naturally as aging. For example, a Treasury note that matures in April 1997 has three years remaining to maturity. If we move ourselves ahead to April 1995, this note will have only two years remaining to maturity and will carry a yield similar to other 2-year Treasury notes. In a positive yield-curve environment, the 3-year Treasury's yield will fall and its price will rise as it ages to the 2-year maturity (assuming no general change in yields or yield curve shape.)
This rolldown process adds significant returns in a low-yield environment. Table I shows the impact of rolldown for 1993. For intermediate-maturity bonds, rolldown contributed 57 to 112 basis points of additional return during the year (these figures exclude returns generated from the general decline in yields during 1993). In today's environment, these amounts are substantial. Long-maturity bonds are less influenced by rolldown effects because the yield curve flattens out in longer maturities.
In today's environment with narrower-than-average yield spreads on most non-Treasury alternatives, it is important to assess the risk of an adverse yield (or yield spread) change. Breakeven analysis is helpful here. Breakeven analysis quantifies the amount of an unfavorable move that a portfolio can sustain and still "break even" with the original position.
For example, Table II calculates the breakeven yield changes for various extensions along the yield curve. The table shows that, over a 1-year horizon, interest rates can rise 1.68% (i.e., 168 basis points) before a 2-year Treasury underperforms cash. A 5-year Treasury outperforms cash unless yields rise more than 91 basis points over the forthcoming year. A five-year Treasury outperforms a two-year Treasury as long as interest rates rise by less than 48 basis points. A 10-year Treasury can sustain only a 4 basis point rise in yield before it underperforms a five-year Treasury.
Breakeven yield spread changes also can be derived. For example, assuming a one-year investment horizon, a 30-year corporate bond (with a 100 basis point yield advantage over Treasuries) can withstand only a 9 basis point spread widening before underperforming the comparable 30-year U.S. Treasury bond. A 5-year issue (with a 60 basis point advantage over Treasuries) has 17 basis point spread protection. A 2-year issue has a much more significant basis points of yield spread protection (even with "only" a 50 basis point initial yield advantage over Treasuries). There is less spread protection in longer-maturity issues.
Breakeven analysis is a method of controlling risk in a bond portfolio. It serves as a reminder that the protection against rising rates and wider yield spreads is much slimmer now than it was only a few years ago.
There are many opportunities for an active bond manager in today's interest-rate environment. Rolling forward settlement of newly issued mortgages can generate 75 to 100 basis points in incremental return over taking delivery and holding pools of mortgages. High-coupon Treasuries should continue to perform well as the demand for current yield remains strong, stripping continues, their relative scarcity increases and their value in a bear market is recognized (i.e., reinvesting large coupons at progressively higher interest rates). Selling volatility, either by using options or by buying callable securities, can add incremental return. Playing the basis between bonds and futures is another value-adding technique.
The Treasury STRIPS market presents many opportunities. For example, a 9-year STRIPS (maturing May 15, 2003) provides an 81/2% total return over a one-year investment horizon if interest rates remain stable and the yield curve is unchanged in shape. In a low-yield environment, an 81/2% return is very attractive, particularly for a government-guaranteed piece of paper with no reinvestment risk. Should rates rise, an investor can hold the STRIPS to maturity in nine years and capture a 71/4% annual return, approximately 5% above the current rate of inflation (as measured by the GDP price deflator).
Sector selection and security selection are very important skills to have in today's bond market. A mere 10-basis-point narrowing in the yield spread of a given sector or security translates into 42 basis points additional return for a 5-year issue, 72 basis points for a 10-year bond and 118 basis points for a 30-year security. These are big numbers in a low-yield environment. By using corporate floating-rate notes or interest-rate swaps, a manager can capture a good portion of the corporate credit spread curve while at the same time limiting interest-rate risk substantially. Synthetic securities also present opportunities as a result of market inefficiencies.
Risk control is paramount in managing bond portfolios in any interest-rate environment. Interest-rate risk, yield-curve risk (from non-parallel shirts in yields), yield-spread risk (from non-Treasury sectors and securities), structure risk (from calls and pre-payments), and credit risk are common to most portfolio managers. The newer forms of risk include foreign currency risk, sovereign/political risk (e.g., emerging market countries), international yield risk (e.g., international bond yields rise relative to U.S. yields), and product risk (e.g., unexpected behavior of esoteric mortgage securities and structured products with embedded options/leverage).
In a low-yield environment, nominal returns tend to be low and the "yield cushion" is much thinner than in an environment of high interest rates. Consequently, the margin for error is small and inferior performance is more noticeable. A carefully planned strategy of "not making mistakes" may emerge as an active manager's modus operandi. Tactics along these lines include limiting exposure to sovereign risk and/or below investment-grade credit risk, avoiding the duration extension risk of certain mortgage-backed securities, and placing time limits on barbell yield-curve swaps and currency-hedged foreign bond positions.
Traditional risk measures can be misleading in today's steep yield-curve environment. For example, duration assigns a higher risk to long-maturity bonds than to short- and intermediate-maturity bonds. However, if short-term interest rates rise substantially and long-term interest rates are stable to only slightly higher, then long-maturity bonds are actually less risky than shorts and intermediates. These in-depth portfolio risk assessments are a critical part of an active manager's job.
The low interest rates we see today have painfully brought home the danger of a mismatch between a pension plan's assets and liabilities. Many pension plans have long-duration liabilities (i.e., obligations) that are funded with short-duration assets. In a rising interest-rate environment, this can work to the plan's advantage; however, in a falling interest-rate environment, the plan can lose some or all of its overfunding or become underfunded.
Ryan Labs has created a "liability index" (of 15 years average duration) to estimate the growth on the liability side of a pension plan. Ryan's liability index grew 22.46% during 1993, vs. 9.75% for the Lehman Brothers Aggregate Bond Index and 10.06% for the S&P 500 Stock Index. For the last five years, 1989-1993, the figures are: liabilities, 103.94%; bonds, 70.63%; and stocks, 97.11%. Whether or not they realized it, many plan sponsors and consultants have been bearish on the bond market. By using short-duration benchmarks such as the Lehman Brothers Aggregate Bond Index, they have been betting implicitly on higher interest rates, and still are.
With interest rates still low relative to 20-year averages, perhaps that bearish bet is a good one. But it is, nevertheless, a bet - and a substantial one at that. In a low interest-rate environment, even a modest drop in interest rates has a significant impact on bond returns. For example, a 50-basis-point decline in long-term yields sees the Ryan liability index grow by approximately 15% over a one-year period. A 100-basis-point decline watches the liabilities increase approximately 23%. With long-term Treasuries yielding 71/2% and inflation under 3%, it is quite possible to see long-term yields fall by 50 to 100 basis points. The popular bond market indexes (with durations of around five years) will lag liability growth by 5% to 11% if long-term rates fall 50 basis points to 100 basis points from current levels.
If interest rates remain stable, liabilities continue to compound at a higher rate than assets because of the steepness of the yield curve. An extra 50 basis points of annual compounding really adds up over time. Compound interest is powerful; Albert Einstein termed it "the eighth wonder of the world.'
The pension asset/liability mismatch is still a major problem that must be addressed. The Pension Benefit Guaranty Corp. recently reported a $15 billion increase in corporate plan underfunding during 1992. Public plan underfunding recently has received front-page press coverage. A bond manager can help a plan sponsor or consultant deal with the asset/liability issue by demonstrating the sensitivity of long-term cash flows to modest changes in interest rates (both up and down) and by illustrating the benefits of being a patient, long-term investor.
Value of an active manager
Active bond management is particularly important in today's interest-rate environment in that active managers have the ability to make duration adjustments, to ascertain value in new markets (e.g., international bonds) and in new products (e.g., synthetics), and to uncover value in traditional products. The active manager can assess and control the risk of a bond portfolio with the wide range of analytical tools available today.
Today's interest-rate environment demands a focus on yield, rolldown, risk control, breakeven analysis, asset/liability imbalances, alternative markets and the special features of individual issues. Many value-based opportunities remain in the marketplace. The astute bond manager is paid to capitalize on these market inefficiencies for the betterment of a pension plan's beneficiaries.