Tag Archives: bonds

Low Fixed Income Returns and What it Means For the Future

Usually when I see the words ‘fixed income’, I immediately think two things: low risk and low return. From what I have learned and extrapolated in my finance classes, bonds and other such fixed income securities are used as safe assets in investors’ portfolio, ‘guaranteeing’ (I use that word loosely) a steady, relatively low level of income. As I found out to my surprise today though, the low level of income may only be the case for individual investors. The buying and selling of bonds, currencies, and commodities (collectively known as FICC) have accounted for more than half of investment banks’ revenue in recent years! Take a look at the following graph:

investment_banks_fi_revenue

 

Unfortunately for investment banks, however, that fraction has been dropping since 2009.  As a recent article in the Economist, “The Engine of Investment Banking is Spluttering,” explains,

In 2009 the world’s big investment banks earned nearly $142 billion from FICC—63% of their total revenue, according to Coalition, a data firm. By last year that had halved to nearly $74 billion, accounting for slightly less than half of revenue (see chart). In 2013 alone revenues from FICC fell by almost 20%.

The article goes on to point out that this trend has not stopped in 2014. Across the world, investment banks’ fixed income revenues have fallen and this drop has been most prominent in Europe:

Huw van Steenis, an analyst at Morgan Stanley, reckons Europe’s leading investment banks gave up about five percentage points of market share in FICC to the three leading American banks last year.

A valid question to ask is why is this happening?

There seem to be two main reasons. The first is a cyclical argument, justifying the drop in FI revenue because of current economic policy. The second reason is related to increased financial regulation. I will discuss both of these reasons below.

The Cyclical Argument

From an economic policy perspective, the first four months of 2014 have been characterized by the Fed’s QE tapering and adoption of forward guidance, which is the name given to the Fed’s recent efforts to keep long term interest rates low. This effort is mostly driven by the Fed’s economic forecasts and communications with the public. So how does this relate to low fixed income revenues? Stable and low interest rates make for slim bond trading profits. Low interest rates mean that bond prices are relatively high and stability means that banks have less chance to take advantage of price changes.

The Regulation Argument

Although this argument relates more to Europe (Swiss banks are especially stringent), it is also relevant to the rest of the world. Generally speaking, financial regulation is becoming more restrictive globally. Banks are required to hold more capital in order to trade, the U.S. has banned banks from trading on behalf of their clients, and there has been a global effort to move derivative trading to central clearing houses. All of these things force investment banks’ profits down.

I think the main effect this decrease in fixed income revenue will cause is a shift on the part of investment banks toward equities. However, I don’t think this shift will last very long because once the Fed starts raising interest rates again fixed income will once again be attractive because spreads will be higher.

New Regulations on Municipal Bonds

Today it was announced that the Treasury will form a new unit to monitor the municipal bond market. The group will be led by former JP Morgan municipal banker, Kent Hiteshew, and will have similar authorities as the SEC, such as the right to create and enforce rules and regulations. The $3.7 trillion municipal bond market experienced problems this past year as Detroit filed for bankruptcy and Puerto Rico continues to have debt issues. The new group will supposedly monitor public pension funds as well as municipal projects, such as bridges and roads. (WSJ – Treasury Turns its Gaze to Municipal Bond Market)

The development of the new unit likely has been created in order to prevent a market blow up in the chance that Puerto Rican bonds default. Despite Puerto Rico making verbal commitments to honor their debt obligations and their treasury department working with the United States Treasury Department to sort out their books, a Puerto Rico default could have tremendous ramifications for the entire market. Currently three out of four municipal bond mutual funds have exposure to Puerto Rican bonds. Due to the tax exemption benefits that municipal portfolios offer many individuals, institutions, insurers, endowments, and corporations hold high exposure to municipal bonds. With this high exposure comes high risk because in the off chance that Puerto Rico is forced to default on its debt obligations, the effects will be felt throughout the entire market.

To complicate things further, last week big name hedge funds including Paulson & Co., Brigade Capital Management, Fir Tree Partners, Och-Ziff Capital Management, and Perry Capital each invested over $100 million into the new $3.5 billion Puerto Rican debt offering. (WSJ – Hedge Funds Roll Dice on PR) This new offering even came after news hit that Puerto Rico hired debt restructuring lawyers and advisers this past month. Unless these funds have better information than the general public, it seems they are taking a risky gamble on the future of Puerto Rico’s debt and are placing their faith in the help from the US Treasury Department.

Today’s news about the forming of the new municipal group could be a sign that the Treasury acknowledges its need to keep Puerto Rico afloat due to high exposure that Puerto Rico has in the entire market. As details arise this spring about the new regulatory group, we will be able to fully understand what capabilities Hiteshaw and his crew will have. For now it sounds like the US government is committed to ensuring that there will not be another instance like Detroit, for investors in Puerto Rican bonds this could be good news.

Rising Rate ETFs

In a Weekend Investor article in the Wall Street Journal, the author Joe Light describes how trends in bond ETFs are changing amid the expected rise in interest rates in the near future. ETF, which is an acronym for Exchange Traded Fund, is essentially a portfolio of assets that typically track some underlying index. For instance, if you were to purchase one of the popular SPDR S&P 500 ETF (pronounced “spider”), you’re essentially buying a small piece of every company within the S&P 500 stock index basket. There are many benefits to buying a low-cost ETFs, including the possibility of diversification and liquidity. A good primer on ETFs can be found from the youtube channel of Blackrock, which is an asset management firm and industry leader in ETF investments. 

ETFs can offer investors greater liquidity than through investing in individual securities because, while the overall size of the ETF may be large, the size of the holdings of any given asset within the ETF is much smaller. For instance, if someone purchased $1Billion worth of single company, or a small portfolio of companies, and later decided to sell all of their shares at once in what is called a “fire sale,” then the added supply of shares in the market would cause the underlying asset prices to drop. In this case, the investor might have to sell for a significant loss to get his/her money out right away. However, if one bought $1 Billion worth of  SPDR “SPY” ETFs based on the S&P 500 and decided to sell the whole ETF at once, the prices of the underlying assets might shrug off the effects. In this case, you may have only invested $2 million in each company (assuming equal weights within the portfolio), which is typically not enough to dramatically affect the supply and price of an asset.

An ETF can cover a range of assets as narrow as a single industry such as oil and gas, or as broad as an entire market, so an investor can essentially choose how diversified their portfolio is. For instance, if you were an investor that had purchased a diversified international equities index fund, but were hoping to also hedge your investments against fluctuations in stock market, one could buy a bond ETF that would be composed of assets like Government Treasury Bonds, Corporate Bonds, or asset backed securities.

While bond portfolios might in normal times make an attractive investment for those wishing to diversify their portfolios, many investors are currently hesitant to touch them due to expectations of a rise in interest rates in the near future, given the U.S. Federal Reserve’s decision to begin to wind down its quantitative easing purchases. So if the artificial demand for bonds created by the FED will soon be lifted, likely causing bond yields to increase and prices to drop, how can a bond investor sensibly make money on these trades? The answer is hedging.

Many companies including Blackrock and WisdomTree Investments have launched plans for hedged bond ETFs that will protect investors from the ever-more-likely drop in the price of bonds. One such ETF is called a zero-duration ETF, which is a portfolio that both goes “long” on bonds (meaning you purchase bonds) while going “short” on certain bonds and derivatives (such as by shorting U.S. treasuries or Treasury futures contracts). In this case, a short is when you borrow a share of an asset, immediately sell it, and then pledge to the lender to return the share at a later date by purchasing another share at (hopefully) a lower price. This “hedging” allows investors to essentially place bets on both sides of the market; if interest rates and bond yields fall, then the investors profit from the rise in the price of their bonds, but if bond yields rise then the investor can offset much of the losses in their bond portfolio by the increased return from their “short” bets.

While there are many benefits to hedging, including in using hedged bond ETFs like the zero-duration ETF, the costs are also larger. Hedges can add to the cost of a portfolio because the investor must purchase instruments such as futures contracts, or place money on margin to short an asset (margin is somewhat like a security deposit; in the case that an investor can’t afford to buy back a share that it borrowed from the broker, the broker gets to keep the margin). If investors invest in high-fee hedged ETFs without looking at the annual management fees, then they might be disappointed in the size of the returns after the wealth managers take a cut. Overall, there’s a price to safety in unstable markets, so investors would be wise to consider all of the investment choices available to them before they let a broker touch their nest eggs.

(Revised) Owning Bonds Despite a Bearish Perspective

During the financial crisis, the Federal Reserve (Fed) cut the federal funds rate from above 5% to below 1% and has not raised rates since.

fredgraph_effectivefedfunds

As seen above, the grey shaded area represents the recent financial crisis. After reaching the zero lower bound (ZLB) in late 2008, the federal funds rate target has remained at 0.00-0.25%. With interest rates unable to go any lower due to the ZLB, the only way interest rates can move is upwards. The only question is – when will the Fed decide to raise rates?

Although I have been bearish on bond prices for some time, I have not traded on this perspective because I did not know when rates would rise. I am bearish on bond prices because bond yields and bond prices have an inverse relationship (ex. when interest rates rise, bond prices fall). As the economy improves, the moment that interest rates rise (and bond prices subsequently fall) approaches. Following the march FOMC meeting, I have come to believe that rates will rise in 2015. According to the Wall Street Journal, “If you expect lower returns from an asset class than it has provided historically, such as lower returns from bonds, then the math, and probably logic, would tell you to lighten up on bonds”. In order to lighten up on bonds, I would need to sell any bonds that I own. However, I do not own any bonds so I have considered shorting bonds instead through an exchange-traded fund (ETF) such as ProShares UltraShort Lehman 20+ Year Treasury.

Although this investment logic might be right, I have made a mistake by not having any exposure to bonds in the first place. According to the Wall Street Journal, “To be clear, the solution is not to eliminate bonds from your portfolio because they will still provide the very important diversifying benefit of cushioning your portfolio if the market should pull back”. Diversification is an important part of asset allocation that helps reduce the variance of expected returns through decreasing (and potentially eliminating) unsystematic risk from one’s portfolio. In a well-diversified portfolio, only systematic risk remains. On the one hand, systematic risk is correlated among all securities (i.e. macroeconomic news). On the other hand, unsystematic risk is uncorrelated among all securities (i.e. industry or company specific news). Traditionally, stock prices and bond prices have demonstrated a negative correlation. Adding bonds to my portfolio, which consists entirely of large cap U.S. equities, would offer me meaningful benefits through diversification. Recently, irregularities in the relationship between stock prices and bond prices (i.e. a positive correlation) due to quantitative easing might lead one to think that the benefits of diversification are lessened or eliminated. According to Burton Malkiel, “But note that even though correlations between markets have risen, they are still far from perfectly correlated, and broad diversification will still tend to reduce the volatility of a portfolio” (212). Although Malkiel was not referring to quantitative easing, he makes a useful point. As long as two securities are less than perfectly correlated (i.e. less than 1), then there will be benefits from diversification. With my portfolio consisting entirely of large cap U.S. equities, I could reduce the variance of my portfolio’s expected returns through diversification.

Despite my bearish view on bond prices, there are still ways for me to purchase bonds and gain the benefits of diversification. My bearish view on bonds is due to interest-rate risk. In this case, increasing interest rates will push down bond prices. If I wanted to still purchase bonds in order to diversify, then I could purchase bonds with short maturities. The shorter the maturity of a bond, the less it is subject to interest rate risk. This can be seen in the yield curve, which has a positive slope as maturities increase (and the credit rating remains fixed). Although the prices of short term bonds will still fall as rates rise, there will still be benefits from diversification.

As I attempt to adjust my portfolio’s asset allocation, I will consider both diversification and my bearish perspective on bonds. On the one hand, I will purchase bonds with short maturities. On the other hand, I will sell (i.e. sell short) bonds with long maturities. As a small investor, I will use ETFs in order to implement my strategy because it is more cost effective.

Owning Bonds Despite A Bearish Perspective

I enjoy following financial markets and implementing investment ideas in which I am confident will perform as expected. Recently, I have become bearish on bond prices. I am bearish on bond prices because interest rates are low and are expected to begin rising in mid-2015. Bond yields will rise as interest rates rise, which also means bond prices fall (i.e. bond yields and prices have an inverse relationship). As a result, I am thinking of ways that I can trade on this perspective. According to the Wall Street Journal, “If you expect lower returns from an asset class than it has provided historically, such as lower returns from bonds, then the math, and probably logic, would tell you to lighten up on bonds”. In order to lighten up on bonds, I would need to sell any bonds that I own. However, I do not own any bonds so I have considered shorting bonds instead through an exchange-traded fund (ETF) such as ProShares UltraShort Lehman 20+ Year Treasury.

Although this investment logic might be right, I have made a mistake by not having any exposure to bonds in the first place. According to the Wall Street Journal, “To be clear, the solution is not to eliminate bonds from your portfolio because they will still provide the very important diversifying benefit of cushioning your portfolio if the market should pull back”. Diversification is an important part of asset allocation to protect against the random walk of financial markets. For example, eliminating my exposure to bonds and only being exposed to stocks puts me at extreme risk of loss if the stock market declines. According to Burton Malkiel, “But note that even though correlations between markets have risen, they are still far from perfectly correlated, and broad diversification will still tend to reduce the volatility of a portfolio” (212). With my portfolio consisting of 100% large cap United States equities, I am subject to a significant amount of volatility. By adding some exposure to bonds, I might be able to reduce the volatility of my portfolio.

Despite my bearish view on bond prices, there are still ways for me to invest in bonds and gain benefits from diversification. My bearish view on bonds is due to interest-rate risk. In this case, increasing interest rates will push down bond prices. If I wanted to still purchase bonds in order to gain some exposure, then I could purchase bonds with short maturities. The shorter the maturity of a bond, the less it is subject to interest rate risk. This can be seen in the yield curve, which has a positive slope as maturities increase. Although the prices short term bonds will still fall as rates rise, there will still be benefits from diversification.

In addition to interest-rate risk, bonds are also subject to default risk that arises when a debtor fails to pay back the creditor. If a debtor is thought to have a high risk of default, then that debtor is charged a default risk premium and charged a higher rate of interest. If I wanted to still purchase bonds in order to gain some exposure, then I could purchase bonds with a higher risk of default. This is another way to still own bonds and decrease interest rate risk. In addition,  there will be benefits from diversification.

Why the Bond ETF Inflow May Not Signal What We Think It May

The article titled “Cash Flies Into Bond ETFs,” published today in the Wall Street Journal by author Carolyn Cui, talks about how February is on track to have the biggest investment inflow into US listed bond ETFs since the launch of the first bond ETF in 2002. According to the article, as of February 21 there has been more than $16 billion of cash inflow into bond ETFs. The article claims that much of the money that is being piled into bond ETFs is in response to poor economic data, emerging market volatility, and desire for income-generating investments. From what we know about fixed income investments, we know that bond prices move inversely with interest rates. With the imminent ending of quantitative easing many are anticipating an increase in interest rates, so this begs the question why would there be a massive inflow to bond ETFs as bond prices should decrease in response to the higher interest rates.

Widespread concern for domestic and international markets could be reason for investors to push money into safer bond ETFs, as investors may accept bond price depreciation out of fear of the global markets. This trend could be supported by the negative reversal of emerging markets such as, Turkey and South Africa, as well as suspicious export numbers coming out of China. Despite the concerns in the global markets, I believe that the high level of inflow is unlikely attributed entirely to the suspect global economic conditions. With rising interest rates many of these ETFs will fall because of the inverse relation between bond prices and interest rates. Furthermore, it’s hard to argue that the economic forecasts for domestic markets has been grim enough to call for a mass inflow to the bond markets, especially after the Fed publicly declared its confidence in the domestic economy. The high level of inflow into bond ETFs is likely more of a reflection of the changing demands of investors.

Last year fixed income mutual funds saw withdrawals of $85.4 billion in 2013, while fixed income ETFs took in $27.5 billion. This capital transfer from mutual funds to ETFs shows that many investors would rather put money in bond ETFs due to the lower costs, increased liquidity, and precision that ETFs allow for. Morningstar fund analyst, Michael Rawson, said “Financial advisors continue to switch toward lower cost ETFs and as they prefer the flexibility and precision that some niche ETFs allow.” He further stated that “the trend may be helping ETFs mash some of the outflows from fixed income.” (WSJ – Bond ETFs Grabbed Money Last Year as Bond Mutual Funds Suffered) From the inflows it appears as if ETFs are surpassing traditional mutual funds in popularity. This trend is likely to continue as many asset management firms have petitioned the SEC to issue actively managed ETFs that only require quarterly disclosure of asset holdings, rather than constant disclosure. If actively traded ETFs are approved it is likely that ETFs will take over mutual funds all together, and we will see an even larger outflow from mutual funds into ETFS.

What Should I Do With My Money: Stocks vs. Bonds

The most important question on every single investor’s mind is: what should I do with my money? Should I mainly invest in stocks or bonds for the optimal risk-return payoff?

In this article, I am going to analyze major investment themes over the past few months, which might give us a hint on asset allocation going forward.

First, let’s think about the correlation between stocks and bonds prior to any trend analysis. Known as two distinct asset classes, they are mostly negatively correlated if we consider their trading volumes as the criteria. Nevertheless, they are more like a complement rather that a substitute to each other in the sense that diversification is the key to any investment portfolio.

Phase 1

5

In the past year of 2013, equity investments dominated the headline. Shown by the FRED graph above, the S&P 500 index rallied 30% over the year, the biggest since 1997, amid improving economic fundamentals and market confidence. At the beginning of the year, the settlement of a critical financial challenge called the fiscal cliff, which referred to automatic spending cuts and tax increases, removed the uncertainty about growth momentum. In particular, investors reallocated their assets to the equity market in anticipation of increasing treasury yields. As the Fed was about to taper its bond purchase program, treasuries might not be a safe-haven anymore because their value would decrease significantly if the yields were to rise from around 2% in early 2013 to their historical average of 5%.

Phase 2

In January this year, capital began to flow back into bond funds for the first time after seven straight weeks of outflows. Traditional U.S. stock mutual funds and exchange-traded funds together saw withdrawals of $18.8 billion in the week ended Feb. 5. Meanwhile, taxable bond mutual funds and ETFs soaked up $10.7 billion, their biggest intake on record, Lipper’s data showed. From my perspective, the shift was primarily due to an adjustment to the U.S. economic projection. Indeed, the economy had been on an upward trend but the strength of recovery might be originally set too high. Besides, the turbulence in emerging markets partly pared confidence in equity investments in today’s interconnected markets.

Phase 3

Most recently, individual investors are jumping back into stock trading, driving business at some discount brokerages to near record levels. At the International Traders Expo in New York, one of the largest conferences for active investors, many of them showed great enthusiasm in equity investment on optimistic economic outlook. Kim Githler, chief executive of MoneyShow Corp., which runs the event, said attendees seemed as enthused as they were before the financial crisis. “People are feeling excited and back in the game,” she said. “The energy is so different.” However, the risk is that they are betting on stock prices at the tail end of a historical rally, given the fact that the S&P 500 declined 3.6% in January, the largest one-month drop since May 2012.

Conclusion

I believe investors are being used to the Fed’s tapering and rationally diversifying their portfolio by adding more bond holdings, instead of solely focusing on equities like what they did in 2013, leading to increased stability in the capital markets.

Increasing Bond Prices in the Wake of a Perceived Economic Recovery

With a burgeoning American stock market and the Fed’s announcement to start cutting back its bond-purchasing program, the field was set for bond prices to drop in the beginning of 2014. It seemed likely that investors, seeking higher returns, would shift their investments from bonds to equities. As a recent article in The Economist points out, however, this is not the case so far this year. Bond markets are actually doing surprisingly well.

Instead of rising since the end of 2013, yields on benchmark ten-year bonds, which are inversely related to prices, have fallen in America and Europe (see chart). Yields on US Treasuries have slipped from 3.01% to 2.88%; on British gilts from 3.03% to 2.86%; and on German bunds from 1.94% to 1.83%.

So far the story is pretty straightforward: yields on bonds are falling, causing bond prices to increase. Before we go any further I want to pause and ask a couple of questions in order to focus our analysis. (1) Why are bond prices and interest rates inversely related? (2) How are inflation, bond prices, and interest rates related? (3) Given we understand the answers to the previous two questions, why are bond prices rising in the wake of an apparent economic recovery? Shouldn’t demand for bonds fall as investors shift their money to the stock market?

(1) Why are bond prices and interest rates inversely related?

We answered this question in class today, but for the sake of clarity and my own learning I’ll summarize it again here. Purchasing a bond allows you to receive a stream of future cash payments from the borrower in the form interest payments (aka coupon payments) and the eventual repayment of the principal when the bond matures. Ignoring inflation expectations and credit risk, the bond price is calculated by summing the present value of each of these coupon payments plus the present value of the bond at maturity. To find the present value of each of these payments, their future value is discounted (aka divided) by the yield (aka the interest rate of the bond). Thus it is clear why a bond’s price and its corresponding interest rate are inversely related: as the interest rate rises, each coupon payment is discounted (aka divided) by a larger amount, causing the total bond price to decrease.

(2) How are inflation, interest rates, and bond prices related?

This is an important question that I don’t think we covered as much in class. I’m sure most people taking this class know the answer already, but it’s nice to get a quick refresher. Simply put, bonds hate inflation. High inflation and high-expected inflation cause future coupon payments to lose value. As a consequence, lenders demand higher yields (aka interest rates rise) and the price of the bond falls. This explanation, however, is a bit too simple. Inflation expectations affect short-term and long-term interest rates differently, so bonds with different terms to maturity will be affected differently. These effects are summarized quite nicely in a concept/graphic called the yield curve.

(3) Why are bond prices rising in the wake of an apparent economic recovery?

This question doesn’t have as much of a straightforward answer as the other two, but the main two reasons I’d like to discuss are low inflation expectations and poor job figures. As I’ve discussed in previous blog posts inflation rates across the developed economies have remained low and show no signs of rapid growth:

In America the price index targeted by the Fed (which aims at 2% inflation) has been rising by less than 1%. In Britain consumer-price figures published on January 14th showed inflation hitting the Bank of England’s 2% target, after four years above it. The fillip to bond markets from low inflation is stronger still in the euro zone, where consumer prices rose by just 0.8% in the year to December and core inflation (stripping out volatile items like energy and food) fell to a record low of 0.7%.

These low inflation figures cause long-term interest rates to fall, which, in turn, cause bond prices to rise.

Another reason is the underwhelming jobs figures that were released on January 10th:

Economists had expected employers to add around 200,000 jobs in December; the actual number was a lowly 74,000.

Poor jobs figures may be a sign that the economic recovery is not as strong as investors thought, causing some investors to hesitate in investing in the stock market and buy up bonds instead.