A flagging consumer price index contains the bear market in bonds

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Part 2
A flagging consumer price index contains the bear market in bonds PART 2 OF 5

Why does low inflation keep the bear market in check?

Real interest rates

The below graph reflects the real interest rate in both the ten-year U.S. Treasury bond and federal funds deposit rates—overnight deposits. It’s important to note that real yields in the U.S. ten-year bond are really not that low on a real basis. At the end of 2013, the ten-year bond had a yield of roughly 3%, while inflation was running at close to 1%, netting a real yield of roughly 2%—not terribly out of line with post-1990 levels. As the below graph shows, when the Federal Reserve Bank lowers its Fed Funds interest rate, there’s some lag in the long-term ten-year rates moving higher as the economy recovers.

This article examines the changes in real interest rates in the USA and the implications for fixed income investors. For a detailed analysis of the U.S. macroeconomic environment supporting this series, please see Must-know 2014 US macro outlook: The crack in the debt ceiling.

Why does low inflation keep the bear market in check?

Negative real interest rates in the short end of the yield curve

In order to spur the economy post–2008 crisis, the Federal Reserve Bank lowered its overnight deposit rate to nearly zero, or 0.10%. After subtracting the inflation rate, as reflected in the U.S. Consumer Price Index, or CPI, we see that the real yield on the federal funds rate has remained in negative territory for some time. The actualization of negative real interest rates serves as a stimulus for savers to invest rather than to simply sit on their money and incur an associated decline in their savings’ value commensurate with the negative real interest rate. Typically, these low rates—and especially negative rates—push capital into new investments, which in turn lead to an economic recovery.

What’s different this time?

While the low interest rate environment in the U.S. has contributed to record corporate profits and rising stock prices, it would appear that there hasn’t been a significant recovery in investment required to lead to a strong recovery in economic growth. As we pointed out in an earlier series, it might appear that capital has “gone on strike,” and reinvestment in fixed long-term investments isn’t occurring as much as it had in prior economic recoveries. For further analysis of the lack of fixed investment in the current economic recovery, please see the related series U.S. investment: Have capitalists gone on strike?

For fixed income investors

For fixed income investors, deflation and the low interest rates that typically accompany deflation are bond price–friendly. However, should the Federal Reserve Bank succeed in reaching its inflation target of 2.0% or slightly higher, the real overnight rate of Federal Funds deposits could become even more negative, and increased inflation levels could trickle into longer-dated bonds. This development would lead to price declines in long-dated bonds and long-duration ETFs such as TLT.

To see how the Federal Reserve Bank’s $4 trillion in asset purchases is affecting bond yields, please see the next article in this series.

For additional longer-duration alternatives to LQD and AGG, please see the series on fixed income ETFs Key strategy: Will deflation contain the bear market in bonds?

Short duration, higher credit risk: SNLN & BKLN

If investors are concerned about a rising rate environment, they may wish to consider short-duration fixed income exposure through short-duration fixed income ETFs such as the Highland/iBoxx Senior Loan ETF (SNLN). This ETF holds senior bank loans, which offer a floating rate coupon based on short-term interest rate pricing—typically the 90-day interbank rate, known as “three-month LIBOR.” (LIBOR stands for the “London Interbank Offer Rate on Deposits,” and it’s established daily through a consortium of banks under the British Banker’s Association in London.)

Similarly, the Invesco PowerShares Senior Loan Portfolio ETF (BKLN) also holds senior bank loans and also has a short duration. The duration of these “floating-rate” loans is typically 40 to 60 days—much shorter duration than the typical four-year duration associated with similar corporate five-year bond portfolios. The loan portfolios also carry an additional advantage over longer-duration corporate bonds in that they have a much higher average recovery of loss rate compared to corporate bonds—closer to 80% compared to closer to 50% in the case of similar rated bonds.

It’s important to note that both these ETFs invest in loans that are rated in the BBB-B area and involve more risk of loss than portfolios rated in the AAA-A area. However, what they lack in credit rating they tend to compensate for in terms of higher returns. SNLN offers a yield-to-maturity of around 4.8%, and BKLN around 4.95%.

Longer-duration, lower-credit-risk alternatives: AGG & LQD

If you’re wary of credit risk, you could also consider longer-duration ETFs such as the iShares Core Total U.S. Bond Market ETF (AGG). It maintains a duration of 5.11 years, though it has a yield-to-maturity of 2.14%, as it holds roughly 70% of its portfolio in AAA and AA rated bonds. Similarly, the iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD) offers a duration of 7.49 years and a 3.35 yield-to-maturity, and it holds the majority of its bonds in the A to BBB category. Like LQD, AGG also holds high-quality commercial credits, such as Verizon (VZ)(0.09%) and GE Corporation (GE)(0.08%). Like SNLN, BKLN also holds lower-rated commercial credits, such as Fortescue Metals Group (FMG)(1.96%) and Valeant Pharmaceuticals (VRX)(1.48%). Note that the individual holdings of BKLN and SNLN are much larger than the holdings of the higher-credit-quality holdings of LQG and AGG, reflecting the greater diversification and the lower level of default-related losses associated with AGG and LQD.