Early in 2016, we are witness to a “hard assets” liquidation frenzy, the likes of which have not been seen for many years. The great commodities supercycle that was supposed to accompany the rise of the BRICs (Brazil, Russia, India and China) to economic heavyweight status has turned into a spectacular bust. The rooms once crowded with “Peak Oil” enthusiasts have long-since emptied and crude continues its plunge from the triple digits to below the thirty dollar per barrel mark.
Carmen Reinhart and Kenneth Rogoff, whose best-selling post-crisis playbook, “This Time is Different,” the one that led many to prepare for imminent hyper-inflation in the G-7, must be watching mouths agape as markets price in record-low inflation expectations. Slack capacity is everywhere. Sovereign bonds of most major countries press to ever-lower, even negative, yields. Inflation is dead.
In theory, the post-crisis financial world was not supposed to work this way. The Nobel laureates told us that major financial crises, such as we saw in 2008-09, presaged more inflation and higher government bond yields, not lower ones. How could they be so wrong? The best answer I can think of is Yogi Berra’s: “In theory there is no difference between theory and practice. In practice there is.”
Managing fixed income, we don’t need to predict every aspect of the economy. However, there is a call we cannot avoid. Do we occupy a position in the long end of the curve, where bond prices rise with falling rates and fall with rising rates? Or do we stay at the short end of the curve where changes in the yield curve have little effect on bond prices? I won’t keep you in suspense. I am in the short duration camp. You may have figured that from our average duration in the Pender Corporate Bond Fund of less than two years. Let me explain our position.
If Interest Rates are Cyclical, the Cycle Bottom Must Be Near
Are declines in government yields secular or cyclical? I know, there are very smart people who write about quasi-permanent “liquidity traps” and “the new normal.” They sound very compelling when they argue in favour of rates staying lower for longer than you or I can imagine. But then I look at the picture below.
Figure 1: United States 10 Year Treasury and Baa Corporate Bond Yields 1923-2015
Source: World Economic Forum
Breathing in, breathing out. Rates rising, rates falling. This picture seems so natural and smooth. Are there compelling narratives and powerful forces that explain why we are pushing towards the zero bound? Of course there are. Just as there were similarly compelling narratives about inflationary spirals in the late 1970s.
We may be wrong, or early, or both. But this looks like a cyclical market to me, and we appear to be much closer to the bottom of the historic range than the top.
Long Duration Positioning is a Crowded Trade
Almost no bond managers who have the freedom to choose duration are running short duration portfolios right now. According to Morningstar, over 85% of bond funds are in excess of two years average duration with most over five. And the few funds that do occupy the short duration positioning are typically mandate-driven short duration funds.
There are a number of reasons for the positioning of the majority of fixed income portfolios. The most important one is that rates at the long end of the curve are somewhat higher than they are at the front end. In an era where returns after fees are generally very low, every little bit helps. In addition, the trend has rewarded this positioning, with only short counter-trend breaks of rising rates, for more than thirty years. Short duration managers, as a rule, would have underperformed for most of recent history.
Financial assets, at least in large quantities do not behave like Wayne Gretzky. They accumulate at places where the puck has been, not where it is going. This alone doesn’t mean a reversal in the trend of the yield curve has to happen tomorrow, but it is hard to imagine a major trend change of this nature without the bulk of assets being positioned in the wrong place. And right now, the bulk of managed bond assets are at long tenors that are quite sensitive to changes in interest rates.
The Upside and Downside Trade-off is Positive for Short Duration
Another reason to be close to the short end of the curve compared to the long end has to do with the simple math of upside and downside. The twelve month return calculation of a one year duration bond the return calculation is as simple as earning your yield to maturity less any credit costs.
But think about the situation for long-dated bonds. If you own the thirty year US Treasury bond, and rates stay the same for one year, then your result will be 2.8%. If rates return to the all-time low 30 year yield of 2.2%, your upside over one year would be 2.8% in coupon and 14% in price increase of the bond. That’s the upside. But if, on the other hand 30 year rates return to a historically unremarkable level of 5% then that 30 year bond price will decline by -33%. While the numbers are less dramatic at shorter points in the curve, the implications are the same — rates rising just a couple of points from current levels will create larger losses for investors than the gains that might result from hitting all-time record lows.
The irony, of course, is that bonds are investments favoured by the risk-averse investors. But with rates so low, the mathematics of risk has shifted to the point where long bonds no longer provide risk free return but are set to deliver, in the words of Bill Gross “return-free risk.” Consider the ten year “Swissie” bond, with a yield of negative 0.2%. Here the base case return is negative before fees, and the downside, in the event Swiss 10 year yields moved to a historically unremarkable 5%, would be a 39% markdown of principal value. Simply put, very low yields have turned long duration bonds into dangerously levered bets on even modest changes in interest rates. We have chosen not to take a seat at that particular casino.
Disruptive Technologies and Corporate Credit – the Future ain’t what it used to be
In the particular case of corporate credit, there is another reason to prefer short duration. The emergence of disruptive technologies has created significant questions about long run viability in many older industries. With the accelerating decline in per-kilowatt cost of electricity produced from solar power, people are starting to ask, quite reasonably, how long the world will need fossil fuels. With the explosive growth of Netflix, YouTube and other cloud-cached video, how long will cable operators remain viable? With the growth in e-commerce, what is the future of the big box retail store? There are massive quantities of five to 20 year bonds issued by corporations active in these industries. How many of those dinosaur issuers will still be around to pay out at maturity?
We have already seen casualties. The profitability of the recorded music industry evaporated in the last decade. Long distance voice telecom, once producing massive cashflows, completely disappeared. An industry as mundane as taxicabs has seen the value of taxi medallions drop by more than 90% as Uber changed the economics of this industry. The economy may do just fine as customers and forward thinking companies adapt to a changing reality. But particular corporations (and their hefty debtloads) which are tied to evaporating cash flow streams may fall victim to the “destruction” part of “creative destruction. It is nice to think that one can guess who the winners and losers will be many years into the future, but staying short duration in corporate credit can relieve us of the requirement to be clairvoyant.
Of course it is one thing to know what is going to happen, quite another to know when it is going to happen. We can see certain potential catalysts out there to change the direction of the falling interest rate trendline.
One signal that has been fairly clear and consistent over the past two years is that the US Federal Reserve under Chair Janet Yellen is committed to “normalizing” US monetary policy from the abnormal zero interest rate policy Ben Bernanke’s Fed deployed in the aftermath of the 2008-09 financial crisis. Yes, I expect there are nuances to be seen in execution, but the basic message of “normalization” is higher US policy rates. We are witnessing a market tantrum at the moment, but where the US leads, others generally follow. We are not fighting the Fed here.
A second potential catalyst is the current under-investment in commodity production capacity that the current meltdown is creating. The longer the miners and other commodity producers go without investing in new productive capacity, the more significant the price shocks will be when demand returns. These shocks may prove to be only temporary in nature, but each of the commodity busts in recent history (and in particular, the ones that ended in 2003 and 2009) were met with significant inflationary pops in commodity prices. And as goes inflation, so goes the direction of interest rates.
A third catalyst, possibly longer term in nature, may come from the emergence of “overt monetary finance,” otherwise known as “helicopter money.” Discussed in the past by Ben Bernanke, recently we witnessed more concrete proposals by Adair Turner, the former head of the UK Financial Services Authority. Speaking to a November 2015 IMF conference, Turner suggested overt monetary finance as a solution to the chronic slack industrial capacity that plagues the certain major economies. By pushing debt-free money into consumer hands through cash tax credits or other bonuses, it seems plausible that demand may be boosted from the centre in a manner that could reverse the currently negative trajectory of inflation.
We have no crystal ball, but overall we see strong rationale for staying short duration in our credit mandate. We are near record low yields for investment grade and government securities in a credit market where rates have demonstrated to be long-term cyclical. We observe active managers crowding towards the longer end of the spectrum. We see the risk/reward mathematics of long-dated maturities becoming increasingly negative. We watch corporations with major near-term technological risks issuing very long-dated bonds.
Putting it all together, the case seems to be compelling to keep a short maturity focus. While keeping a short duration will result in somewhat lower portfolio yields in the current market than in stretching to five years and beyond, we find plenty of well-covered near term corporate bonds trading above 5% yields, despite choppy conditions.
18 January 2016