Bond Investment

Posted on October 2, 2013 by David Laidlaw

Interest rates have gyrated fairly drastically since May of this year when the Federal Reserve first indicated that it would eventually reduce its monthly bond purchases. Yields on 10-year US Treasury Notes have increased from a low of approximately 1.7% earlier in the year to a high of 3.0% in early September. Given these changes, bond prices depreciated sharply during this period; the Barclays Aggregate Bond Index lost about 6% between late April and early September and certain sectors lost considerably more.

Since the Federal Reserve’s recent announcement that it would not taper its bond purchases, bond prices have rallied and rates have fallen back to about 2.6% for the 10-Year US Treasury. Given this volatility, the question arises as to how to best position a bond portfolio in the current environment.

Our core bond portfolio holds high credit-quality fixed-income securities that mature within the fairly near future. We have consistently managed bond portfolios that contain highly rated issues. This philosophy stems from our belief that the primary purpose of bonds is to hold or gain value during times of stress in the stock market. For growth, we take calculated risks investing in stocks. Therefore, we want the bonds to provide downside protection if the market falters. High quality bonds provide a much better hedge against the risks inherent in the stock market than lower-quality bonds that often move in parallel to common stocks.

Our bond portfolios also have shorter durations in aggregate than the bond market as a whole. The average duration of these portfolios is roughly 3.7. Duration is a measurement of a bond’s sensitivity to changes in interest rates. Therefore, the portfolio would be expected to gain 3.7% if interest rates fall by 1%. Conversely, the portfolio would fall by the same 3.7% if interest rates rise by 1%. This portfolio is less sensitive than the Total US Bond Market as a whole which has a duration of about 5.

We still view rising interest rates as the greatest threat to all bond portfolios for a number of reasons. The first reason is that interest rates are historically depressed. Aside from the current period, the yield on the 10-year US Treasury has only been below 3% for the period starting in 1935 until the mid-1950s over the past 140 years. These statistics are from Professor Robert Shiller’s data set available online at Yale University’s Economics Site (http://www.econ.yale.edu/~shiller/data.htm).

The other reason that we believe interest rates will most likely rise in the future is that the Federal Reserve cannot continue to buy bonds indefinitely. By buying $45 billion in Treasury Notes per month, the Federal Reserve is buying a majority of all Treasuries that are issued by the US Government. This process cannot continue indefinitely without triggering a currency war amongst countries or runaway inflation. Therefore, the question is not whether or not the Federal Reserve will slow and/or stop buying Treasuries, but when this change will occur.

Our typical bond portfolio provides a yield-to-maturity of about 1.7% that is slightly greater than the CPI which has increased only 1.5% from August of 2012 to August of 2013. To further protect the portfolio against rising rates, we could reduce the duration further; however, that change would lower the yield to maturity. The yield on the 1-year US Treasury Note is only 0.10%. Therefore, holding a portfolio this short in duration would cause the portfolio to lose about 1.4% per year in terms of real purchasing power. We are not willing to get too conservative regarding reducing the duration of the bonds in accounts, since yields could remain depressed for an extended period.

Many managers and advisors have chosen to allocate their clients’ portfolios to low-quality and longer-dated bonds. The problem with this approach is that these portfolios will experience significant capital losses when interest rates rise. If the increase is disorderly as occurred over the summer, the capital losses could be significant. In contrast, our bond portfolios will have lower yields to maturity, but we believe this course is more prudent given the risk of rising rates.