Bursting the Bond Bubble Babble

By Andy Martin June 11, 2013 Advisor Perspectives welcomes guest contributions. The views presented here do not necessarily represent those of Advisor Perspectives. Interest rates will eventually go up. The 50 !asis point spi"e in May on the 10 year Treasury !ond #ay have !een the !eginning. But despite industry and #edia assertions, history shows that there is nothing to $ear $ro# rising rates. The $und industry is %reating untested and potentially ha&ardous invest#ents to deal with the per%eived threat. My resear%h shows that in rising rate environ#ents, total returns are generally positive, not negative. Investors should shorten duration and diversi$y into #ulti asset $i'ed in%o#e port$olios, whi%h are sa$e, proven, %ost e$$e%tive and easy to i#ple#ent. These port$olios have histori%ally outper$or#ed during rising rates. What if rates go up? Bill (ross, #anager o$ the )IM*+ Total ,eturn -und, said May 10 that the se%ular 30 year !ull #ar"et in !onds li"ely ended April 2.. /avid ,osen!erg, %hie$ e%ono#ist and strategist $or (lus"in 0he$$ 1 Asso%iates, said in early May that his 2love a$$air with the !ond #ar"et has %o#e to an end.3 The 4all 0treet Journal reported in May that .56 o$ e%ono#ists !elieve that the yield on the 10 year Treasury will !e higher in /e%e#!er. Are (ross, ,osen!erg and the e%ono#ists surveyed %orre%t7 )ro!a!ly. 8ow rising rates will a$$e%t !ond returns, however, is de!ata!le. The pro!le# is that there is no de!ate. The industry has an un%hallenged %onvi%tion that interest rates will ro%"et up, !ond pri%es will %ollapse and !ond investors will !e ruined. -or!es %o#pared the %o#ing !ond rout with the great tulip #ania o$ 193:. The 4all 0treet Journal warned investors to 2wat%h out3 and that the 2sword o$ /a#o%les3 hangs perilously over their heads. A panel o$ e'perts told Barron;s to 2s"ip !onds3 altogether. Those warnings have !een #ade with su%h a!<e%t %ertainty that one would guess that this %ollapse has happened !e$ore. It has not, at least in any o$ the #ost nota!le periods o$ rising rates=

The worst !ear #ar"et in #odern history, whi%h ended 30 years ago. June 1.50 to June 1.52, when 10 year Treasury !onds rose >.56.
1

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May 1.53 to June 1.5>, when !onds rose 3.26. August 1.59 to August 1.55, when !onds rose 2.16. +%to!er 1..3 to @ove#!er 1..>, when !onds rose 2.96. @ove#!er 1..5 to /e%e#!er 1..., when !onds rose 2.16. /e%e#!er 2003 to August 2009, when the -ederal -unds rate rose >.36.

History is on our side The last se%ular !ear #ar"et in !onds ran $or 30 years, ending around 1.50. 4hat were the results7 @o#inal returns were up, not down. In #any su! periods, even real returns were up. In a previous arti%le, I analy&ed retail !ond #utual $unds Aad<usted $or survivorship !iasB, !ond inde' returns, Treasury !onds and a hypotheti%al dis%ounting #odel. Ca%h told a %orro!orating story= The worst !ear #ar"et $or !onds in #odern history resulted in positive total returns $or !onds. Di"ewise, there has !een si#ilar good news sin%e 1.50. *hart 1 shows returns $or : to 10 year and 30 year Treasury !onds $or the $ive periods when rates rose !y #ore than 26 and one re%ent period where the -ederal -unds rate rose >.256. These were the si' #ost di$$i%ult interest rate environ#ents $or investors in the last 30 years.
Chart 1 Inter#ediate Treasury vs Dong ter# Treasury returns during rising interest rates @o#inal 10 yr Tsy yield rise >.526 3.156 2.0.6 2.936 2.016 0.916 Average Annuali&ed ,eturn : 10 yr Tsy 3.336 >.>>6 3.956 9.:16 1.3:6 2.536 *u#ulative ,eturn 9.::6 >.526 :.506 :.296 1.>.6 9.5.6 Average Annuali&ed ,eturn 30 yr Tsy 0.956 11.5>6 2.996 15.106 13.:96 >.1.6 *u#ulative ,eturn 1.306 12.>56 5.256 19.2:6 1>.5>6 11.5.6

)eriod

5E31E50 5E31E52 >E30E53 5E31E5> :E31E1.59 :E31E1.55 .E30E1..3 10E31E.> 11E30E.5 12E31E.. 11E30E2003 :E31E2009

10-yr: Citi !"#$ Treasury %-10 year &0-yr: Citi Treasury "enchmar' &0 (ear )T* !+ !ource: ,orningstar Advisor -or'station

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*hart 2 shows an eFually weighted port$olio o$ the three #a<or $i'ed in%o#e Gsu! %lasses= Treasury !onds, %orporates, and #ortgages, plus the Bar%lays H0 Aggregate Bond Inde' during the sa#e periods. @owhere in these nu#!ers do you $ind a $inan%ial de!a%le. ,ising interest rates have !een no #at%h $or well diversi$ied investors. Chart 2 CFually weighted Inde' port$olio returns during rising interest rates )eriod @o#inal 10 Ir Tsy yield rise >.526 3.156 2.0.6 2.936 2.016 Inde' )ort$olio Average Annuali&ed ,eturn 3..>6 2.1.6 9.:.6 2.>56 0.096 Inde' )ort$olio *u#ulative ,eturn 5.0>6 2.356 1>.096 2.9.6 0.0:6 *u#ulative ,et Bar%lays H0 Agg Bond T, H0/ 11.2.6 0..>6 12.>36 3.316 0.526

5E31E50 5E31E52 >E30E53 5E31E5> :E31E1.59 :E31E1.55 .E30E1..3 10E31E.> 11E30E.5 12E31E..

11E30E2003 :E31E2009 0.916 2..>6 5.036 5.936 #nde. portfolio of: "arclays ! ,"! T* #nde./ Citigroup "road #nvestment$rade/ Citigroup Treasury &-% year/ e0ually-weighted. !ource: ,orningstar Advisor -or'station Two periods e'perien%ed negative returns. ,eturns will not always !e positive in a rising rate environ#ent, nor will they !e !etter than when rates de%line. But investors did not e'perien%e the disasters a!out whi%h so#e warn. 4hy7 -all !treet 1ournal reporter Jaty Burne re%ently wrote, 2The yield on the ABar%lays H.0. *orporate 8igh Iield inde'B has lost #ore than a per%entage point this year, in a sign o$ he$ty de#and $or in%o#e produ%ing se%urities.3 0he %orre%tly identi$ied i#portant !ond pri%e varia!les G supply and de#and G that are not part o$ any $or#ula. Bonds pri%es are su!<e%t to supply and de#and in the sa#e way as sto%"s are. The de#and $or !onds will rise, not $all, when interest rates go up. This %ounter !alan%ing $or%e te#pers !ond pri%e drops even as rates rise. Too much focus on the Federal Funds rate @o#inal yields on 10 year Treasurys rose only 91 !asis points $ro# 2003 to 2009 Athe last row o$ returns in %hart 2B, !ut the -ederal -unds rate in%reased !y >.256 A%onsisting o$ 1: Fuarter point #ovesB.
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0in%e the -ederal -unds rate is at the %enter o$ #u%h o$ the %o##entary a!out rising rates, it is instru%tive to show what happened the last ti#e it went up. Many investors worry that when the -ederal ,eserve $ires the -ederal -unds starting gun, all o$ the other horses will dash, with inter#ediate and long ter# rates rising apa%e. This did not happen the last ti#e short rates went up. It too" al#ost three years $or 10 year Treasurys to reali&e that the ra%e had !egun, as shown in in *hart 3. The total return o$ the inde' port$olio was 5.036 Aas shown in %hart 2B during one o$ the steepest -ederal -unds in%reases in history. Chart 3- Fed Funds rate and 10-year Treasury yield from Dec 2003 through July 2006

8ow did the -ederal -unds rate rise so dra#ati%ally without a$$e%ting !ond yields7 +ne reason is that the -ederal -unds rate is the only rate that govern#ent sets. +ther interest rates are set !y #ar"et $or%es. /uring slow e%ono#i% periods when loan de#and is relatively low, !an"s are relu%tant to push up interest rates. Ban"s would rather #aintain loan volu#e at a thinner #argin than <eopardi&e !usiness !y raising rates. Why the dismal warnings about rising rates? The industry and $inan%ial #edia, perhaps unintentionally, #isstate the e$$e%ts o$ rising rates. +ne reason is si#ple and partially e'%usa!le= There is a#!ivalen%e toward histori%al data. This goes under the general heading o$ the o$t repeated #antra, 2It;s di$$erent this ti#e,3 and is rooted in the a%ade#i% environ#ent where theory reigns. -or e'a#ple, the distinguished #athe#ati%ian -is%her Bla%" wrote in 1..3= 2I $ind theory to !e $ar #ore power$ul than data when we;re trying to esti#ate e'pe%ted return. 4hen I read an
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e#piri%al paper, I usually see" out the theory se%tion and ignore the ta!les.3 Dater, Bill 0harpe said= 2I have %on%luded that I #ay never see an e#piri%al result that will %onvin%e #e that it dis%on$ir#s any theory.3 Theoreti%al %onstru%ts su%h as the %apital asset pri%ing #odels and ar!itrage pri%ing theory are pre$erred to data !ased o!servations. Theories are i#portant. Their study !uilds analyti%al tools to e'plain the dyna#i%s o$ #oney #anage#ent. And studying the past is no #ore relia!le than theory. But theories do not ne%essarily have !etter tra%" re%ords than tra%" re%ords. +ur predi%tions o$ the $uture should !e in$or#ed and te#pered !y histori%al perspe%tive. 4e need !oth data and theory. 0o#e in the invest#ent industry #a"e wild assu#ptions a!out what a%tually happened during past rising rate %y%les. Instead o$ positing steady long ter# in%reases in rates G the histori%al pre%edent G #odels assu#e rate spi"es. Thus, an analyst #ight say, 2I$ rates go up !y 36 in <ust one year, the unlu%"y owner o$ a 30 year !ond would lose >:6,3 without pausing to %onsider that the 30 year Treasury has rarely gone up 36 in one year. Bond pri%ing is too %o#ple' to !e e'plained in a single $or#ula that o#its supply and de#and, $ails to re%ogni&e that less attra%tive alternative invest#ent options #ay %ushion pri%es andEor does not a%%ount $or %redit Fuality %hanges. -ew !other to as" who !uys 30 year Treasury !onds. I have wor"ed in the invest#ent industry $or over 30 years and have never #et anyone who a%tually owned su%h a !ond. They are pri#arily owned !y H.0. and $oreign govern#ents, institutions and the -ederal ,eserve, not !y individuals. Below are the returns o$ the : year and 30 year Treasury !onds $or the worst two #ar"ets A#easured !y 30 year Treasury !ondsB in the last >0 years. *ivili&ation %an survive a 106 short ter# drop in short or inter#ediate !onds, even i$ the 30 year Treasury drops 156. Chart 4 4orst 1 year !ond #ar"ets in >0 years )eriod @o#inal 30 yr Tsy yield rise 3.306 3.506 *u#ulative ,eturn : yr Tsy ..:36 5.1.6 *u#ulative ,eturn 30 yr Tsy 15.556 1>.526

3E31E:. 2E2.E50 5E31E50 >E30E51

%--yr: !T*2A! T-"ill Cnst ,at *ate %-yr &0-yr: !T*2A! T-"ill Cnst ,at *ate &0-yr !ource: ,orningstar Advisor -or'station
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Could marketing be a reason? Another reason why the e$$e%ts o$ rising rates are #isstated is less <usti$ia!le. There is an unFuen%ha!le thirst $or yield now, in any $or#. This is natural when !ond rates are at histori% lows. In response, the invest#ent industry is loo"ing everywhere to !oost yields, without loo"ing %losely at theory or data. -or e'a#ple, the 4all 0treet Journal re%ently reported that investors are see"ing additional yield !y investing in high yield !onds, e#erging #ar"ets !onds, dividend paying sto%"s, real estate invest#ent trusts A,CITsB and #aster li#ited partnerships AMD)sB. 8ow did these $ive su! %lasses per$or# in 20057 Chart 5 ,eturns o$ non-traditional in%o#e produ%ing assets in 2005 Invest#ent Type MD) ,CIT 8igh /ividend 0to%" C#erging Mar"et Bond 8igh Iield Bond Inde' 2005 Alerian MD) T, H0/ M0*I H0 ,CIT Kanguard 8igh /ividend Iield Inde' J)M CMBI (lo!al /iversi$ied Bar%lays Ba to B H.0. 8igh Iield T, *u#ulative ,eturn 39..16 3....6 32.516 12.036 22.536

!ource: ,orningstar Advisor -or'station *o#pare those returns with traditional in%o#e produ%ing assets $or the sa#e year. Chart 6 ,eturns o$ traditional $i'ed in%o#e assets in 2005 Invest#ent Type Mortgage Ba%"ed (lo!al (overn#ent H0 Invest#ent (rade *orp H0 Treasury International Bonds Inde' Bar%lays H0 (@MA Inde' Bar*ap (lo!al Treasury C' H0 iBo'' L DiFuid Invest#ent (rade Bar%lays H.0. Inter#ediate Tsy Bo$AMD (ll Br M"t @on 0ov e' H0/ *u#ulative ,eturn :.5:6 ..>36 0..96 11.356 0.506
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!ource: ,orningstar Advisor -or'station @evertheless, the industry responded to the per%eived yield appetite. 0in%e 2011, #ore than 306 o$ new issues o$ in%o#e o!<e%tive e'%hange traded $unds were in those $ive 2non traditional3 su! %lasses. +nly three in%o#e o!<e%tive CT-s, roughly 36 o$ the new issues, were $ully diversi$ied !ond port$olios in #ore than two $i'ed in%o#e su! %lasses with no sto%"s, derivatives or leverage. Additionally, Morningstar $ound that 30. !ond #utual $unds owned sto%"s at the end o$ /e%e#!er G the highest nu#!er in at least a de%ade. Clsewhere, a re%ent Inde' Hniverse !log post highlighted $ive #ulti asset In%o#e CT-s that have 2%o#e o$ age.3 The writer e#phasi&ed that these are 2here to stay,3 !ut 906 o$ the assets held !y those $unds are in assets other than $i'ed in%o#e, in%luding MD)s, eFuities, real estate, A#eri%an depository re%eipts and alternatives. 4hen I entered the invest#ent industry 30 years ago, $i'ed annuities and %ash were used as !ond pro'ies. @ow we are to !elieve that eFuities, real estate and MD)s are suita!le su!stitutions. What about shortening maturities and diversifying instead? 4hat is a sa$er alternative than allo%ating to non $i'ed in%o#e asset %lasses7 The 10 years ending /e%. 31, 2012, was the $irst sin%e the 1.50s that the returns on Treasury !ills underper$or#ed the in$lation rate. T !ills no longer %an !e e'pe%ted to outper$or# in$lation. I$ we are entering a long ter# period where $i'ed in%o#e returns will !e !etween 26 and 36, as Bill (ross has suggested, we %an #anage it. In%o#e investors are #ore interested in preserving prin%ipal and lowering volatility than eFuity investors. They will trade the %han%e o$ potential higher returns $or a #ore predi%ta!le per$or#an%e. Dauren%e 0iegel o$ the ,esear%h -oundation o$ *-A Institute said, 2)eople thin" !onds are sa$er than sto%"s and you;re supposed to get your #oney !a%". M I$ people lose #oney in !onds it;s going to hurt.3 Investors should shorten #aturities and diversi$y solely a#ong $i'ed in%o#e asset su! %lasses. The %hart !elow illustrates returns during the $ive toughest periods o$ rising interest rates in the last 30 years, #easured !y 10 year Treasury yields, and the re%ent period when the -ed -unds rate in%rease !y >.256. The last %ategory, 212 Asset,3 is an eFual weighting o$ ea%h o$ the 12 #a<or ta'a!le !ond %ategories. ,eturns were higher in shorter duration and diversi$ied port$olios than in single asset long ter# allo%ations.

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Chart
0trategies in rising rate periods G N 0horten #aturities 30 yr Tsy *u#ulative ,eturn 1.306 12.>56 5.256 19.2:6 1>.5>6 11.5.6 : 10 yr Tsy *u#ulative ,eturn 9.::6 >.526 :.506 :.296 1.>.6 9.5.6 /iversi$y 3 Asset *u#ulative ,eturn 5.0>6 2.356 1>.096 2.9.6 0.0:6 5.036 Bar%lays H0 Agg Bond T, *u#ulative ,eturn 11.2.6 0..>6 12.>36 3.316 0.526 5.936 12 AssetO *u#ulative ,eturn nEa nEa nEa nEa 5..56 13.:.6

)eriod

@o#inal 10 yr Tsy yield rise

5E31E50 5E31E52 >E30E53 5E31E5> :E31E1.59 :E31E1.55 .E30E1..3 10E31E.> 11E30E.5 12E31E.. 11E30E2003 :E31E2009

>.526 3.156 2.0.6 2.936 2.016 0.916

10-yr: Citi !"#$ Treasury %-10-yr &0-yr: Citi Treasury "enchmar' &0-yr )T* !+ !ource: ,orningstar Advisor -or'station & assets: #nde. portfolio of "arclays ! ,"! T* #nde./ Citigroup "road #nvestment-$rade/ Citigroup Treasury &-% year/ e0ually-weighted. !ource: ,orningstar Advisor -or'station

When less is not more 4ith $i'ed in%o#e investing, #ore is #ore G the #ore disparate assets, the !etter. @o one puts sto%"s into one %ategory, nor should we with !onds. Morningstar re%ogni&es nine style !o'es $or sto%"s, not in%luding international eFuities. Bond allo%ations should !e %o#prised o$ at least as #any su! %lasses. 0tart with three #a<or su! %lasses= %orporate, Treasury and #ortgage !a%"ed !onds Aas I did with the 2inde' port$olio3 a!oveB. Then, su!divide into the 12 #a<or ta'a!le !ond su! %lasses= agen%ies, !an" loans, %ash, %onverti!les or pre$erreds, e#erging #ar"ets, high yields, international %orporate, international govern#ent, invest#ent grade %orporate, #ortgage !a%"ed, Treasury in$lation prote%ted se%urities and Treasury !onds. @ow you have a truly diversi$ied !ond port$olio. 8ow did this 12 asset, eFually weighted port$olio per$or#7 The inde' version returned a %u#ulative 55.936 %o#pared to the Bar%lays H0 Aggregate Bond T, inde';s return o$ 93.5:6 $or the 10 years ending April 30, 2013. -urther, there was a surprisingly wide dispersion o$ returns, even when interest rates were low. In the 12 #onths ending April 30, 2013, shown in *hart 5, the per$or#an%e ranged $ro# 2.56 to 15.>:6. The %orrelations !etween the 12 asset su! %lasses were .25, .33 and .35 $or the three , $ive and 10 year periods through April 30, 2013, respe%tively.
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I$ the industry were %orre%t in !uilding in%o#e $unds with so $ew $i'ed in%o#e assets, then we would e'pe%t to see 506 to 1006 %orrelation !etween these 12 %ategories o$ !onds. This #ay surprise investors who !elieve that the only way to diversi$y a !ond port$olio is to add sto%"s, alternative assets, or leverage. But it is a good surprise, !e%ause the diversi$ied !ond port$olio redu%ed long ter# volatility and a%ted as a hedge in rising rate periods. Chart ! " #eturns for 12 fi$ed-income su%-classes for the year ending &'ril 30( 2013

I$ we are #oving into a higher interest rate environ#ent, the sa$est, easiest and #ost relia!le way to generate in%o#e and total returns $or %onservative to #oderate investors is to diversi$y into all o$ the availa!le !ond %ategories. This strategy is pre$era!le to adding se%urities or strategies that %ould <eopardi&e investors; prin%ipal, !uying power and %o#$ort. Andrew +. ,artin is president/ co-founder and portfolio manager of %Twelve Advisors/ 33C.
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+irect investment in an inde. is not possible. #nde.es are unmanaged portfolios representing different asset classes/ with varying levels of associated ris'. 4 5Agencies: "arclays ! Agency T*/ "an' 3oans: !6P73!TA 3everaged 3oan T*/ Cash: 8idelity #nstl ,, 8ds ,oney ,ar'et #/ Convertibles7Preferreds: "ofA,3 All Convertible All 9ualities/ 2merging ,'ts: 1P, 2,"# $lobal T*/ :igh (ields: "arclays ! Corporate :igh (ield T*/ #nt;l Corporate: "ofA,3 $lobal "rd ,' 2. ! +ollr T*/ #nt;l $ov<t: "arclays $lobal Treasury 2. ! T*/ #nv $rade Corporate: "arclays ! Credit T*/ ,ort "ac'ed: "arclays $=,A T*/ T#P!: "arclays ! Treasury ! T#P! T*/ ! Treasurys: "arclays ! Treasury yr T* > ,orningstar Advisor -or'station?

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