Many market participants and strategists recently have predicted higher “risk-free” rates, particularly in U.S. Treasuries, for this year.
Last year, the yield on 10-year Treasuries rose to 3.03%, from 1.76%. The resulting price action caused losses in those bonds and in many high-quality fixed-income securities.
The
Barclays Aggregate Bond Index lost about 2% of value on the year. Because most investors think what will happen in the coming year is exactly the same as what just happened (which is usually not the case), many forecast losses for higher-quality fixed income into 2014 and beyond.
Although compared with market consensus, I am much more nervous about the global economic picture, I agree that a period of historically low interest rates isn't the best time to invest in securities such as U.S. Treasuries. But investors who shy away from the bond markets entirely are missing a large and growing number of opportunities.
Many subsectors within the fixed-income market have very little correlation to U.S. Treasuries, and historically, some even exhibit negative correlation. Over the past decade, U.S. high-yield bonds typically have moved higher in price when U.S. Treasuries have moved lower.
This is largely due to the credit risk inherent in high yield. These bonds promise more yield due to the significant uncertainly surrounding prospects for investors' being repaid principal and interest.
When broader economic conditions improve, two things happen: 1) Investors grow less interested in the safety of U.S. Treasuries, which results in higher yields and lower prices of those securities, and 2) Investors become less nervous about the credit risk inherent in high yield, which can lead to higher prices of those bonds.
DECENT RETURNS
But high-yield bonds aren't the only sub-asset class that can provide decent returns, even during a period of rising rates. Various parts of the asset- and mortgage-backed-securities markets can still provide acceptable, even good, returns as rates rise.
Although investors fixate on the single metric of duration, they tend to miss the fact that for many securities, a simple duration figure doesn't fully reflect either the risk or the potential return.
But a much larger or more robust debt universe isn't unequivocally good. The tremendous growth of the subprime-mortgage market in the middle of the last decade didn't end well.
The recent explosion of the bank loan market (which wasn't tracked by Lehman/Barclays at all prior to 2006) is frightening. Investors are ignoring significant credit risks in bank loans and terrible negative optionality — due to those instruments' callability — for the false sense of safety that comes with having very little exposure to rising U.S. Treasury rates (bank loans are generally packaged as floating-rate securities).
LARGER DEBT MARKET
A much larger debt market for an economy that is unchanged in size can mean that less and less debt is held by banks and more is directly held by investors. This is positive and is one reason that the United States has experienced a better recovery from the global financial crisis than Europe.
However, ever-expanding debt markets without fundamental support from a growing economy ultimately indicate an over-reliance on credit growth for economic expansion, which is clearly unsustainable. In any event, today's larger and more diverse marketplace means that investors should spend much more time examining the nature of the risks that they assume when investing across sub-asset classes and across the world.
Debt markets have changed and grown dramatically over the course of the past decade. Thinking of U.S. Treasuries and their attendant risks as somehow representative of the global bond market is as limiting and foolish as equating the Dow Jones Industrial Average to the global stock market.
Although U.S. Treasury rates are low — and certain other sub-asset classes within fixed income look too hot for comfort — investors should be aware of the diversity of risks and opportunities available, and calibrate investment strategies accordingly.
Jason Brady is a portfolio manager and managing director at Thornburg Investment Management Inc.
