Posts tagged ‘duration’

Oxymoron: Shrewd Government Refis Credit Card

Credit Card - FreeImages

With the upcoming Federal Reserve policy meetings coming up this Wednesday and Thursday, investors’ eyes remain keenly focused on the actions and words of Federal Reserve Chairwoman Janet Yellen.

If you have painstakingly filled out an IRS tax return or frustratingly waited in long lines at the DMV or post office, you may not be a huge fan of government services. Investors and liquidity addicted borrowers are also irritated with the idea of the Federal Reserve pulling away the interest rate punch bowl too soon. We will find out early enough whether Yellen will hike the Fed Funds interest rate target to 0.25%, or alternatively, delay a rate increase when there are clearer signs of inflation risks.

Regardless of the Fed decision this week, with interest rates still hovering near generational lows, it is refreshing to see some facets of government making shrewd financial market decisions – for example in the area of debt maturity management. Rather than squeezing out diminishing benefits by borrowing at the shorter end of the yield curve, the U.S. Treasury has been taking advantage of these shockingly low rates by locking in longer debt maturities. As you can see from the chart below, the Treasury has increased the average maturity of its debt by more than 20% from 2010 to 2015. And they’re not done yet. The Treasury’s current plan based on the existing bond issuance trajectory will extend the average bond maturity from 70 months in 2015 to 80 months by the year 2022.

Maturity of Debt Outstanding 2015

If you were racking up large sums of credit card debt at an 18% interest rate with payments due one month from now, wouldn’t you be relieved if you were given the offer to pay back that same debt a year from now at a more palatable 2% rate? Effectively, that is exactly what the government is opportunistically taking advantage of by extending the maturity of its borrowings.

Most bears fail to acknowledge this positive trend. The typical economic bear argument goes as follows, “Once the Fed pushes interest rates higher, interest payments on government debt will balloon, and government deficits will explode.” That argument definitely holds up some validity as newly issued debt will require higher coupon payments to investors. But at a minimum, the Treasury is mitigating the blow of the sizable government debt currently outstanding by extending the average Treasury maturity (i.e., locking in low interest rates).

It is worth noting that while extending the average maturity of debt by the Treasury is great news for U.S. tax payers (i.e., smaller budget deficits because of lower interest payments), maturity extension is not so great news for bond investors worried about potentially rising interest rates. Effectively, by the Treasury extending bond maturities on the debt owed, the government is creating a larger proportion of “high octane” bonds. By referring to “high octane” bonds, I am highlighting the “duration” dynamic of bonds. All else equal, a lengthening of bond maturities, will increase a bond’s duration. Stated differently, long duration, “high octane” bonds will collapse in price if in interest rates spike higher. The government will be somewhat insulated to that scenario, but not the bond investors buying these longer maturity bonds issued by the Treasury.

All in all, you may not have the greatest opinion about the effectiveness of the IRS, DMV, and/or post office, but regardless of your government views, you should be heartened by the U.S. Treasury’s shrewd and prudent extension of the average debt maturity. Now, all you need to do is extend the maturity and lower the interest rate on your personal credit card debt.

Investment Questions Border

www.Sidoxia.com

Wade W. Slome, CFA, CFP®

Plan. Invest. Prosper. 

DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients hold positions in certain exchange traded funds (ETFs) , but at the time of publishing, SCM had no direct position in any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC Contact page.

September 12, 2015 at 10:00 am Leave a comment

Confessions of a Bond Hater

Source: stock.xchng

Source: stock.xchng

Hi my name is Wade, and I’m a bond hater. Generally, the first step in addressing any type of personal problem is admitting you actually have a problem. While I am not proud of being a bond hater, I have been called many worse things during my life. But as we have learned from the George Zimmerman / Trayvon Martin case, not every situation is clear-cut, whether we are talking about social issues or bond investing. For starters, let me be clear to everyone, including all my detractors, that I do not hate all bonds. In fact, my Sidoxia clients own many types of fixed income securities. What I do hate however are low yielding, long duration bonds.

Duration…huh? Most people understand what “low yielding” means, when it comes to bonds (i.e., low interest, low coupon, low return, etc.), but when the word duration is uttered, the conversation is usually accompanied by a blank stare. The word “duration” may sound like a fancy word, but in reality it is a fairly simple concept. Essentially, high-duration bonds are those fixed income securities with the highest sensitivity to changes in interest rates, meaning these bonds will go down most in price as interest rates rise.

When it comes to equity markets, many investors understand the concept of high beta stocks, which can be used to further explain duration. There are many complicated definitions for beta, but the basic principle explains why high-beta stock prices generally go up the most during bull markets, and go down the most during bear markets. In plain terms, high beta equals high octane.

If we switch the subject back to bonds, long duration equals high octane too. Or stated differently, long duration bond prices generally go down the most during bear markets and go up the most during bull markets. For years, grasping the risk of a bond bear market caused by rising rates has been difficult for many investors to comprehend, especially after witnessing a three-decade long Federal Funds tailwind taking the rates from about 20% to about 0% (see Fed Fatigue Setting In). 

The recent interest rate spike that coincided with the Federal Reserve’s Ben Bernanke’s comments on QE3 bond purchase tapering has caught the attention of bond addicts. Nobody knows for certain whether this short-term bond price decline is the start of an extended bear market in bonds, but mathematics would dictate that there is only really one direction for interest rates to go…and that is up. It is true that rates could remain low for an indefinite period of time, but neither scenario of flat to down rates is a great outcome for bond holders.

Fixes to Fixed-Income Failings

Even though I may be a “bond hater” of low yield, high duration bonds, currently I still understand the critical importance and necessity of a fixed income portfolio for not only retirees, but also for the diversification benefits needed by a broader set of investors. So how does a bond hater reconcile investing in bonds? Easy. Rather than focusing on lower yielding, longer duration bonds, I invest more client assets in shorter duration and/or higher yielding bonds. If you harbor similar beliefs as I do, and believe there will be an upward bias to the trajectory of long-term interest rates, then there are two routes to go. Investors can either get compensated with a higher yield to counter the increased interest rate risk, and/or they can shorten duration of bond holdings to minimize capital losses.

Worth noting, there is an alternative strategy for low yielding, long duration bond lovers. In order to minimize interest rate risk, these bond lovers may accept sub-optimal yields and hold bonds to maturity. This strategy may be associated with short-term price volatility, but if the bond issuer does not default, at least the bond investor will get the full principal at maturity to help relieve the pain of meager yields.

Now that you’ve survived all this bond babbling, let me cut to the chase and explain a few ways Sidoxia is taking advantage of the recent interest rate volatility for our clients:

Floating Rate Bonds: Duration of these bonds is by definition low, or near zero, because as interest rates rise, coupons/interest payments are advantageously reset for investors at higher rates. So if interest rates jump from 2% to 3%, the investor will receive +50% higher periodic payments.

Inflation Protection Bonds: These bonds come in long and short duration flavors, but if interest rates/inflation rise higher than expected, investors will be compensated with higher periodic coupons and principal payments.

Shorter Duration: One definition of duration is the weighted average of time until a bond’s fixed cash flows are received. A way of shortening the duration of your bond portfolio is through the purchase of shorter maturity bonds (e.g., buying 3-year bonds rather than 30-year bonds).

High Yield Bonds: Investing in the high yield bond category is not limited to domestic junk bond purchases, but higher yields can also be earned by investing in international and/or emerging market bonds.

Investment Grade Corporate Bonds: Similar to high yield bonds, investment grade bonds offer the potential of capital appreciation via credit improvement. For instance, credit rating upgrades can provide gains to help offset price declines caused by rising interest rates.

Despite my bond hater status, the recent taper tantrum and interest rate spike, highlight some advantages bonds have over stocks. Even though prices declined, bonds by and large still have lower volatility than stocks; provide a steady stream of income; and provide diversification benefits.

To the extent investors have, or should have, a longer-term time horizon, I still am advocating a stock bias to client portfolios, subject to each investor’s risk tolerance. For example, an older retired couple with a conservative target allocation of 20%/80% (equity/fixed income) may consider a 25% – 30% allocation. A shift in this direction may still meet the retirees’ income needs (especially if dividend-paying stocks are incorporated), while simultaneously acknowledging the inflation and interest rate risks impacting bond positions. It’s important to realize one size doesn’t fit all.

Higher Volatility, Higher Reward

Frequent readers of Investing Caffeine have known about my bond hating tendencies for quite some time (see my 2009 article Treasury Bubble has not Burst…Yet), but the bond baby shouldn’t be thrown out with the bath water. For those investors who thought bonds were as safe as CDs, the recent -6% drop in the iShares Aggregate Bond Index (AGG) didn’t feel comfortable for most. Although I am still an enthusiastic stock cheerleader (less so as valuation multiples expand), there has been a cost for the gargantuan outperformance of stocks since March of ’09. While stocks have outperformed bonds (S&P vs. AGG) by more than +140%, equity investors have had to endure two -10% corrections and two -20% corrections (e.g.,Flash Crash, Debt Ceiling Debate, European Financial Crisis, and Sequestration/Elections). If investors want to earn higher long-term equity returns, this desire will translate into more volatility than bonds…and more Tums.

I may still be a bond hater, and the general public remains firm stock haters, but at some point in the multi-year future, I will not be surprised to hear myself say, “Hi my name is Wade, and I am addicted to bonds.” In the mean time, Sidoxia will continue to optimize its client bond portfolios for a rising interest rate environment, while also investing in attractive equity securities and ETFs. There’s nothing to hate about that.

www.Sidoxia.com

Wade W. Slome, CFA, CFP®

Plan. Invest. Prosper.

DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients hold positions in certain exchange traded funds (ETFs), including floating rate bonds/loan funds, inflation-protection funds, corporate bond ETF, high-yield bond ETFs, and other bond ETFs, but at the time of publishing, SCM had no direct position in AGG or any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC Contact page.

July 20, 2013 at 4:05 pm 2 comments

Winning Coaches Telling Players to Quit

How would you feel if your coach told you not only are you going to lose, but you should quit and join the other team? Effectively, that is what Loomis Sayles bond legend Dan Fuss (read Fuss Making a Fuss), and fellow colleagues Margie Patel (Wells Fargo Advantage Funds), and Anthony Crescenzi (PIMCO) had to say about the chances of bonds winning at the recent Advisors’ Money Show.

This is what Fuss said regarding “statistically cheap” equities:

“I’ve never seen it this good in half a century.”

 

Patel went on to add:

“By any measure you want to look at, free cash flow, dividend yield, P/E ratio – stocks look relatively cheap for the level of interest rates.” Stock offer a  “once-in-a-decade opportunity to buy and make some real capital appreciation.”

 

Crescenzi included the following comments about stocks:

“Valuations are not risky…P/E ratios have been fine for a decade, in part because of the two shocks that drove investors away from equities and compressed P/E ratios.”

 

Bonds Dynasty Coming to End

The bond team has been winning for three decades (see Bubblicious Bonds), but its players are getting tired and old. Crescenzi concedes the “30-year journey on rates is near its ending point” and that “we are at the end of the duration tailwind.” Even though it is fairly apparent to some that the golden bond era is coming to a close, there are ways for the bond team to draft new players to manage duration (interest rate/price sensitivity) and protect oneself against inflation (read Drowning TIPS).

Equities on the other hand have had a massive losing streak relative to bonds, especially over the last decade. The equity team had over-priced player positions that exceeded their salary cap and the old market leaders became tired and old. Nothing energizes a new team better than new blood and new talent at a much more attractive price, which leaves room in the salary cap to get the quality players to win. There is always a possibility that bonds will outperform in the short-run despite sky-high prices, and the introduction of any material, detrimental exogenous variable (large country bailout, terrorist attack, etc.) could extend bonds’ outperformance. Regardless, investors will find it difficult to dispute the relative attractiveness of equities relative to prices a decade ago (read Marathon Investing: Genesis of Cheap Stocks). 

As I have repeated in the past, bonds and cash are essential in any portfolio, but excessively gorging on a buffet of bonds for breakfast, lunch, and dinner can be hazardous for your long-term financial health. Maximizing the bang for your investment buck means not neglecting volatile equity opportunities due to disproportionate conservatism and scary economic media headlines.

There are bond coaches and teams that believe the winning streak will continue despite the 30-year duration of victories. Fear, especially in this environment, is often used as a tactic to sell bonds. Conflicts of interest may cloud the advice of these bond coaches, but the successful experienced coaches like Dan Fuss, Margie Patel, Anthony Crescenzi are the ones to listen to – even if they tell you to quit their team and join a different one.

Read Full Advisor Perspectives Article

Wade W. Slome, CFA, CFP® 

Plan. Invest. Prosper. 

www.Sidoxia.com

DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds (including TIP), but at the time of publishing SCM had no direct position in any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.

December 5, 2010 at 11:25 pm 1 comment


Receive Investing Caffeine blog posts by email.

Join 1,775 other followers

Meet Wade Slome, CFA, CFP®

More on Sidoxia Services

Recognition

Top Financial Advisor Blogs And Bloggers – Rankings From Nerd’s Eye View | Kitces.com

Wade on Twitter…

Share this blog

Bookmark and Share

Subscribe to Blog RSS

Monthly Archives