The damage potential of rising bond yields

'Duration' could become the next great risk for investors, Pioneer's Michael Temple says

By Michael Temple

Jul 23, 2013 @ 12:01 am (Updated 5:59 pm) EST

bonds
Michael Temple

The initial goals of the Federal Reserve's great monetary experiment to create negative real yields, spur consumption and cushion the budgetary consequences of fiscal stimulus have largely been accomplished.

For that reason, investors now could face the threat of rising bond yields. Thus, for investors in fixed income, “duration” could become the next great risk in their portfolios.

Duration is a measure of a fixed-income instrument's sensitivity to rising rates. In general, the longer the instrument's maturity, the longer its duration and the more sensitive its price will be to changes in market yields.

This is because the instrument's value is the sum of cash flow received — interest payments and principal payments — discounted at the current rate demanded by investors for that instrument until its maturity. When rates rise, an investor implicitly has to discount all interest and principal payments for bonds at a higher rate, and that rate is compounded by the “time value of money.”

The market usually reacts by dropping the value of the longer-dated bond much more dramatically than the shorter-dated bond. And the math can be painful.

For simplicity's sake, let's compare two bonds, each with identical coupons, each paying interest just once a year. The first is a five-year bond with a 3% coupon, and the second is a 30-year bond with a 3% coupon.

Using the current Treasury curve as a baseline, a 1% upward and equal shift in rates would cause the five-year bond to drop 4.6% in value, while the 30-year bond would lose 17%.

1994 REDUX?

As investors grow increasingly concerned about the possible impact of duration on their portfolios, there is one specific precedent on which many are focusing: The Great Bond Bear Market of 1994. There are many similarities between today and the early 1990s.

Leading up to the Great Bond Bear Market of 1994, a steep recession and financial crisis in the late 1980s and early 1990s was followed by an extended “on hold” phase. Investors were caught completely off guard when the monetary regime shifted and the Fed began tightening.

Although many investors are voicing concerns, market indicators suggest that few expect a meaningful rise in rates before the end of the decade. What this implies is that while investors are paying lip service to concerns about duration, it isn't really reflected in the market.

A FEW SCENARIOS

Over the past month, financial markets have erupted as investors grappled with the ramifications of a dramatic shift in monetary policy. Ironically, despite the fact that monetary stimulus remains on full throttle and interest rate rises are a long way off, fixed-income investors have scrambled to adjust portfolios to this new paradigm.

To provide a framework for investors to better understand the consequences of maintaining exposure to long-duration strategies, I examined Treasury returns under several possible scenarios. Of course, I don't have a crystal ball, but I have assigned probabilities based on expectations of these scenarios unfolding:

1. Bear case: an accelerating rise in employment and inflation (+3% gross domestic product growth), resulting in a 6.5% 30-year yield and a 5% 10-year yield at the end of the time horizon (probability: 25%)

2. Base case: a continued modest acceleration in economic activity (2% to 3% for the next two years), that results in a 5% 30-year yield and a 4% 10-year yield (probability 50%)

3. Stagnant case: sluggish economic activity (1% to 2%) over the next two years that results in a 30-year yield that is 4% and a 10-year yield that is 3% (probability 20%)

4. Bull case: another recession drives the 30-year yield to 2% and the 10-year yield to 1.25% by year-end (probability 5%)

The probability-weighted return of these scenarios are decidedly negative for both 30-year (-14.8%) and 10-year (-5.4%) bonds.

GET READY

The stage is being set for a potential significant change in the fixed-income markets. Investors need to understand how the evolving landscape could affect their allocation to this perceived “safe haven” asset class and investigate fixed-income subsectors that are being viewed as “refuges” from what may be a turbulent transition to higher rates.

Michael Temple is senior vice president and director of credit research for the U.S. at Pioneer Investments.