Rate Hikes: Investor Risk Perceptions and Historical Context
During a recent quarterly webcast for financial advisors, we asked the audience about their clients’ biggest concerns for the remainder of 2015. The four options were:
• Losing money on their equity allocations
• Not earning enough income
• Not keeping up with the stock market
• Losing money on their fixed income allocations
Of these, “losing money on their equity allocations” was by far the most popular response, at just under 40%. On the other hand, only about 10% of respondents selected “losing money on their fixed income allocations.”
The fact that more clients are concerned about stocks than bonds makes sense given media attention on stocks’ prospects, high valuations and a potential rate hike by the Federal Reserve. In our view, caution about equities is well warranted. However, we think there will soon come a time when more investors awake to the risks they are taking in their fixed income portfolios. In our view, those risks are greater than many people realize, both because of potential price impacts caused by rising interest rates and other strains in the bond markets, such as weak covenants and liquidity issues. Given these risks, investors may wish to carefully consider their exposures to bonds.
What would be different this time?
In normal rate hike situations, investors who sit tight and keep reinvesting their dividends (as bond mutual fund investors typically do) eventually offset price losses caused by rising rates through additional income received on bonds issued at those new rates.
But in this environment, the absolute level of income is so low, that relying on a rising income stream to offset bond price losses is unlikely to make investors whole except perhaps in a very long time horizon. In a true bear market for bonds with yields rising but still absolutely low, investors could face a very challenging situation, especially for those in or approaching the distribution phase of their savings cycle (that is, nearing or in retirement). In our view, this is one reason why we think many investors may eventually come to see their bond investments as more risky than their stock holdings.
High yield bear market?
Investors’ intense desire to find yield in the context of a zero-rate policy has supported the high yield bond market in recent years. Furthermore, the high yield market has never seen a true bear market caused by a sharp and prolonged period of rising rates such as occurred in 1973-1974’s parabolic spike in interest rates.
As Jeffrey Gundlach of DoubleLine Capital pointed out recently during an interview on Wall Street Week, the high yield market has existed only during the secular bull market in bonds that started in the early 1980s—it is untested in a prolonged back-drop of higher rates.
Moreover, Gundlach points out that most high yield debt is slated to roll over toward the end of this decade. Investors could be shocked, he says, by markdowns in the price of their high yield bonds (including in mutual funds and ETFs) if a glut of corporate borrowers struggle to roll over obligations at higher interest rates.
We think that scenario is possible given the weak bond covenants that have become endemic in recent years, as the initially tight underwriting standards after the 2008 financial collapse faded into history. Each year has brought not only weaker and weaker covenants but also lower cash flow coverage—and that is the key ratio we need to watch in the aggregate high yield market when thinking about default risk and what level of risk premium is warranted over the yield offered on a given 10-year note.
Though defaults in aggregate are low, except for the energy sector, we saw two recent events that moved the risk premium higher: (1) the 2013 taper tantrum, when the risk premium was narrow and rates spiked up on central bank selling, and (2) the fall in oil prices, wherein the energy sector saw a quick increase in defaults and the aggregate market underwent a credit risk re-assessment, which led to a trading opportunity earlier this year as energy bonds stabilized and oil bottomed.
This recent price action in the high yield market is a sign that there is vulnerability to higher rates and/or a recession even against the backdrop of defaults around 2% versus the average level of 4%. What happens if rates move higher over a long period of time? What happens if a recession brings average yields back to reality once the rising rate cycle brings the economy to a stall, as the cycle has done historically?
Liquidity is another area of concern
Another unknown is liquidity risk. Banks under new regulations cannot hold a high inventory of risky assets—and this includes high yield bonds. Moreover, banks cannot make a market through high levels of trading. These two points combine to create a major question mark, since bank holdings of high yield bonds are about 20% of their 2007 level but the high yield market has roughly doubled in size from pre-financial crisis levels.
Market participants may have been happy with the liquidity of high yield ETFs during the correction brought on from the “taper tantrum” rise in rates during mid-2013, but there has been a steady increase in the bid to ask since the loss of bank-based liquidity. Is this a sign that high yield bonds are vulnerable if we get a prolonged real correction from “normalization” of rates?
With inflated high yield bond market valuations, liquidity providers may demand lower prices to buy any large levels of supply that might take on inherent risks if rates rise. Buyers may be there but at what price? This scenario may increase volatility against a backdrop of rising policy rates.
Policy rate hikes could lead to gradual price deterioration over five years
Against the context of rollover and liquidity concerns, let’s return again to the fundamental scenario of rising interest rates affecting bond prices. Bond prices fall as rates rise since the bonds you hold today with a fixed income stream are worth less than bonds issued with higher coupons. What will happen to prices over, say, a three to five year period of rate normalization—from the current level of zero to, say, policy rates at a 3-4% level?
The FOMC “dot plot” has rates higher than market views based on several different metrics including the low level yields at present. That said, the difference is narrowing, and the bond market has been up and down during 2015, with the bias being prices down and yields up as we move toward mid-year.
The FOMC sees 2015 policy rates at 0.5-0.75 percentage points above zero, then 2016 and 2017 having consecutive increases of about 1.25 percentage points each. That progression would bring policy rates to about 3%. The point here is we are discussing a rising trend that may arrive at around 3% for policy rates. But, even a slow growth, low rate world may mean a further gradual deterioration of bond prices in 2018 and 2019.
Conclusion
A strong dollar and lower than expected inflation may keep a lid on a quick normalization as the FOMC thinks about the effect on a more ‘globalized’ financial system. The end result might be slow painful losses on quarterly statements. As one commentator noted back in 2013, “mom and pop opened their account statement and said they did not know their government and municipal bonds could decline.” Clients expect stability. Avoiding losses in fixed income portfolios is a priority. To achieve this end, we think clients may need more alternative styles that preserve capital as an investment mandate and objective.
Matthew Pasts, CMT, is CEO of BTS Asset Management, Inc., based in Lexington, Mass. www.btsmanagement.com
This commentary has been prepared for informational purposes only and should not be construed as an offer to sell or the solicitation to buy securities or adopt any investment strategy, nor shall this commentary constitute investment advice. This commentary may contain opinions and assumptions that are forward-looking. To the extent this material constitutes an opinion or assumption, recipients should not construe it as a substitute for the exercise of independent judgment. This material has been prepared from information believed to be reliable, but BTS Asset Management, Inc. makes no representations as to its accuracy or reliability. The views and opinions expressed herein are subject to change without notice.
