Fixed Income Investing: July 8th, 2016 Changed Everything


Some things you can only see in retrospect.

The purpose of this article is to argue that we have passed the low point in rates (high point in bond valuations), which will impact valuations of both bonds and equities. An additional purpose of this article is to point out what likely impact this will have on the valuations of those securities if held for an extended period of time. As such, I believe that long-term investors, holders of income securities for years, would feel more impact by the long-term issues discussed in this article; on the other hand, traders may well have less of an interest in the points discussed here, avoiding the influence of the longer-term factors as they maneuver around more frequent, shorter-term signals.

What Do Interest Rate Cycles Look Like

Barry Ritholz published in 2012 a classic blog consisting solely of this view of interest rate cycles over history (original blog found here). He indicated that he loved these long-term charts like this one as they extend over a very long time, as do I.

A second graph below provides a less busy view of the chart above, albeit with a shorter span of “only” 120 years. This graph may allow the reader a more focused, clearer view on “recent” history, covering the mere century long period of long-term interest rates and the identical long rate cycles

(graph obtained from note found here)

With either chart, one can see that long-term interest rates cycle over decades-long periods, an observation which I do not think will surprise any readers of SA.

Starting about 1920, rates cycled down for about 25 years to bottom in the early 40’s. Then, changing direction, rates cycled back up for nearly 37 years in rates to Sept-October 1981, at the peak of Paul Volcker’s “war on inflation.” From those very lofty levels, rates have declined back down to present day lows, requiring about 36 years to do so.

As the latest interest rate cycle is approaching the duration of the previous cycles (or longer) and given very low, “emergency” interest rates, we might be expected to approach the inflection point where rates begin to turn higher. It is also worth noting that interest rates are at record-low levels back to 1900, based upon the second chart, and back to the founding of the country if one uses the Ritholz chart.

If one looks at short rates, one can get an even longer perspective. In the attached chart, please find Bank of England rates back to 1694 (i.e., back 323 years):

(Data from Bank of England website)

One could argue that “we don’t care about no stinkin’ Bank of England rates here in the ole U.S. of A.”; however, recently (in Bank of England terms, over just the past hundred years), BoE and Fed Rates have moved in reasonably synchronous fashion as seen in the attached graph superimposing those same BoE rates (in blue) with Fed Rates (in orange):

(data from Bank of England and St. Louis Federal Reserve website)

Two key observations can be made from this chart:

a) Short rates established by the two central banks appear to be reasonably synchronous, including at this point, making BoE rates a reasonable proxy for the period prior to 1900 (indeed, back prior to the founding of our nation), and

b) Short rates set by both central banks are at all-time lows for all of their respective recorded histories.

Where Are We in the Long-Term Interest Rate Cycle?

Back to long rates, the latest secular period of declining interest rates has extended back over three decades. Provided in the graph below is a record of long-term U.S. Treasury bond rates over the past forty years (other than 2002 and 2006, where there is a gap in the data), which will include the period just prior to the previous peak in rates:

(from data from St. Louis Federal Reserve Bank website)/ppAnd for

U.S. Treasury 10 Year bonds:

(from data from St. Louis Federal Reserve Bank website)

Again, one sees the peak for the long rates that occurred in Sept-Oct 1981 (depending upon whether you are evaluating the 30- or 10-year bond) to the present day. From these graphs, one can see that we are at or near the low point of the cycle. However, it is hard to tell more than that from these graphs as there is insufficient detail provided to see if we are continuing to lower levels or if we have already experienced the lows for the cycle.

To provide a better look at “very recent” data, please find two proxies for long rates here for the “very recent” last three years (from Jan 1, 2015):

(data from U.S. Treasury/St. Lous Fed)

This is “The Chart”, highlighting the central argument of this article that long-term rates have bottomed. This chart reflects movement in two commonly used proxies for long-term rates for the period of time (2015, 2016 and 2017 through August 14th) during which it would appear that long-term rates would reach their lowest point in this cycle last summer. This would imply that we have already seen the lows in long-term rates. Indeed, it appears that the long-term rates bottomed about six months after the Federal Reserve moved the short-term rates off of “zero” (0-0.25%, the lowest rate possible).

Specifically, one can see that the nadir for long-term rates occurred during the week of Independence Day Holiday of last year. Both of these measures reached their low point on July 8th, 2016, with the LTI reaching closing at 1.84% level and the 20 Yr CMT closing at the 1.69% level. Early in the following week, the rates jumped higher and never again reached those exceptionally low levels. Both the 10 and 30 Year U.S. Treasury bonds similarly hit their low points for coupon rate on July 8th, 2016 before springing higher in a similar fashion. Worth noting here is that bonds would be hitting market value highs simultaneously to hitting their lowest rates.

An “Old Trader’s Saw” is that one does not get long to buy or sell tops and bottoms. Beyond the obvious observation that rates hit the lowest point, the overall behavior of rates through this period suggests strongly that rate trends are indeed changing direction. Moving into the low, rates dropped rapidly below successive “floors” of about 2.5%, then 2%, then spikes down to extremely low levels; almost immediately, rate declines reverse course and drive up first above 2%, then 2.5%. Upon returning to higher rates after this short period of time, the rates attempted to rally back to the previous rate lows several times, failing at ever higher lower levels with each attempt. A subsequent test of the 2.5% floor in mid-2017 fails to penetrate through that level. Year-long efforts to continue the prevailing trend downward have all failed; in addition, they have failed at ever higher levels.

This suggests “bottoming” behavior, but do I know for certain? Of course not, and rates could turn down again. Rates could make a delayed run at the old lows as they made attempts to exceed the previous highs two years after the rate top in 1981. However, I would argue that the combination of all of these factors, plus steadily improving economic data and a need to unwind the Fed’s balance sheet, suggest that we have seen the market bottom on long rates (and simultaneous highest valuations for “riskless” long bonds). Anything can happen but, based upon the trading behavior around this period combined with the exceptionally low rates achieved, I believe that I have seen the lowest rates that I will see during the remainder of my lifetime.

One of the reasons that this observation about a bottom in rates was not made more promptly was to provide some time to see if the rates would turn around yet again and drive to even lower levels. Some things can only be seen in retrospect. Promptness in warning about market bottoms could be premature while waiting overly long to create absolute certainty on the call would render such an observation far too late to be of use. It is always a balancing act. As it was, even if we are over a year after what appears to be the bottom, the investing climate has not changed so much that there is not an opportunity to react to this change.

If true, this means that we have already passed from the 35 years, a secular period of declining rates and have just entered a 30-ish year cycle (based upon historical length) of increasing interest rates. The tailwinds that have pushed bonds and equities to ever higher levels over the past 35 years are changing subtly into headwinds, even if it is barely perceptible at this point. All this implies that the prevailing trend of higher interest rates will hold and that strategies for rising rates are now in order, with the old strategies used for declining rates set aside.

So What If We Saw Low Rates Last Summer?:

1. Impact on Rising Rates on Valuations of Securities:

If a rising tide lifts all boats, then a receding tide will result in boats lowered back to more modest valuations. That is, the very engine of declining interest rates that has driven securities, both equities and fixed coupon debt, to relatively high valuations may well now be going into reverse, or may have already gone into reverse without it yet being obvious.

For this audience, I don’t think that I need to illustrate how higher long-term rates will negatively impact the valuation of long-maturity fixed coupon bonds nor how it would pressure price/earnings valuations to lower levels. The discounting mechanisms of ever higher interest rates will pressure the market valuations of long-maturity bonds downward, with this lowered bond value resulting in higher rates needed to match ever higher benchmark rates over time. Likewise, discounting mechanism for earnings value or the cash flows from equity securities will pressure valuations as well; as the benchmark interest rates in the denominator of these calculations go up, the “ratios” (the calculation of value through the discounting mechanism) of these securities will go down.

But Owl, don’t stock markets typically go up as rates rise due to recovery? Yes, but in my view, this is not your typical situation where you are recovering out of a recession. Those recoveries tend to start with valuations at much lower levels (compressed P/Es and other valuation measures) than those currently. Only after the turn in economic activity is recognized do the valuations begin typically begin to rise (e.g., the price/earnings ratios will increase with increased confidence of future, improved earnings). The classic example is the behavior of stocks around the last turn in interest rates in 1981, with equity valuations beginning to recover from very depressed valuations and low P/E ratios.

2. Are Your Investing Strategies Consistent with the Evolving Interest Rate Trend?:

Unless you know how to use a slide rule, you have not invested during a secular period of rising interest rates. Your investing instincts have been honed in a declining interest rate environment only, learning the rules of investing as interest rate structure adjusts only to lower, not higher, rates. I mean this not as a criticism, as this is the only environment offered to you in which to practice, but as an observation for you to be self-aware of the circumstances during which you learned to invest. You may never have thought about it, but I am suggesting that you do.

You have also learned to “buy the dips”. Why not? Even if you made bad choices, to be honest, ever lower interest rates would drive up valuations on almost every investment. Rising tides lift all boats indeed. Even bad investment decisions could get bailed out by overall rising valuations and the investor may not have felt the small penalty of a slower recovery for the bad investment as compared to a good one. If the secular trend has indeed shifted to higher rates, then this is no longer true, and it will not be true for a very long time. Indeed, bad choices will be punished twice-fold, once for their inherent flaws and once for increasing rates pressuring valuations of all instruments, strong or weak.

Many investors will have built a strong reliance on equities and the capital gains that have come from owning them for 35 years. Why not? Equities have been going up, even with intermittent sharp counter-trend declines in ’87, ’94, ’01 and ’08, almost since Reagan was nominated. About that time, you could buy the Dow Jones for one ounce of gold; just for comparison, it now takes 12.7 oz. (DJ of 22,024 and gold at $1,730/oz.). I don’t mean to overstate the importance of this; rather, I just want to use this as an illustration to show how far equities have gone (and how low they were as interest rate peaked to unimaginable levels at the former peak).

3. What Does This Tell Us about Passive versus Active Fund Management:

While this is a bit off-topic and not directly related to the purpose of this article, it is worth noting that active portfolio management may well become more successful and more competitive to passive investment management over the next 30 years than it has over the last 30. If all boats are dropping with an ebbing tide, then SPY and many other broad equity benchmarks will come under pressure at some point. Successful investing in this new environment will require identification of equities that can either grow faster or yield more to compensate for ever more demanding market standards (discounting rates) by which value is measured. Active management (will it include smart beta?) will have a chance to provide value worth the added cost as one tries to separate the wheat (equities that can increase in value faster than interest rates are driving it down) from the chaff (those equities that are unable to overcome higher interest rates). I believe that this will put passive ETFs and mutual funds, which have grown massively during this period, under competitive pressure from actively managed entities, even as the latter have struggled mightily during the previous interest rate regime.

4. At What Point Will Income Investments Compete with Equities Sought for Capital Gains?:

In addition to valuation pressure from higher benchmark rates, higher rates for fixed coupon or variable coupon will provide competition for equities not seen for some time. With equities currently out-yielding bonds in some cases as well as having a growth kicker to boot (pardon the expression), what’s not to like?

However, this structural advantage will revert to a disadvantage with the onset of higher rates. Rates on bonds of all stripes will begin to go up and, at some point, will begin to become competitive again with the beloved DGI investments. The “D” will struggle to keep up, with higher rates pressuring the “G”. This does not require significant market declines; even a dampening of the growth may shift the balance in favor of ever-increasing coupons on credit instruments, especially those levered to variable rates.

Don’t forget: interest rates are key both for valuations of equities as well as an input into earnings (to a greater or lesser degree, depending upon the equity). The valuation of an equity with a constant earnings level will be pressured with higher rates; in addition, however, higher interest rates will create incrementally higher interest expenses for many companies, creating downward pressure on earnings as a result. Thus, higher rates will result in a “double whammy” on many equities, reducing the valuations on earnings even as they pressure the earnings through higher interest costs.

5. “Let’s Undo the ‘Twist’”. One Driver for Higher Long-term Rates Could Be the Unwind of “The Twist” and the QEs:

In 1960, Chubby Checker implored the listener to “Do the Twist”, creating one of the great dance fads of the period. Now, it is time for the Fed to “Undo the Twist”, unwinding the operations of Operation Twist and the QE programs. They have indicated that they will do it in incremental steps carefully to minimize market impact and I believe that they will do it as skillfully as possible. However, it is a bit difficult to sweep about $3T (with a T) under the rug; even if deftly executed and even as they will go with a gradual run-off approach, which appears to me to be the best way to do it, it will be very difficult to overcome the loss of $3T in buying power. I believe that it is the triumph of hope over economic judgment that it will not have a significant impact on long-term rates as this process plays out. Three trillion less buying power going after the same supply will inevitably force rates higher to attract sufficient level of additional buyers to fill the gap.

So What Do We Do?

At this point, I can hear the sharpening of knives by commentators, ready to come after me because I am claiming that the world is coming to an end. However, it is not my intention to argue that, especially not in the short run. One piece of evidence that this is not inevitably a short-term trend is that, even a year after the trend has changed, you can scarcely feel the impact of the change. Indeed, I believe many do not yet even recognize the trend. In addition, the impact of the issues discussed here will play out over years or decades, not weeks or months. The short run has already come and gone, yet one has not seen precipitous moves or perhaps even felt the impact.

I am not writing this to scare people or panic anyone or suggest that you dump all investments, retreating to a cave with canned goods and a gun. I am not suggesting that investors need to do anything precipitous or thoughtless or react emotionally to a changing environment. Panic and emotional reaction are almost never a good investing approaches and I do not suggest that such a reaction is needed.

Rather, I am suggesting that long-term, buy-and-hold investors take stock of where their investments are positioned and begin to consider how they feel about what is in their portfolio. Retirees and those dependent upon savings income have very little capability to absorb large capital losses in pursuit of that income. In a rising rate environment, even as investors liked all of their positions in a declining rate environment yesterday, they may well not like them in a rising rate environment tomorrow.

I do know how to use a slide rule (and, in fact, still own my well-crafted K & E rule). As such, I had spent my early years (during the 1970s) investing into the crescendo of rising rates. I do not anticipate nor suggest (even as I cannot rule it out) that we will see another period of a steep decline in rates creating declines in the market prices of both equities and bonds that are as extreme as that period. I do suggest that the next five or ten or twenty years will look and feel to investors very different than the last ten (or thirty) and that investors not yet taking note should do so.

Here are approaches that I am using and little of it will surprise you. Nothing said here is particularly original nor particularly insightful, as they would represent standard approaches in responding to higher interest rates. I include these standard approaches here, not because I think SA readers are unaware of them, but I do believe that there is a general complacency and an insufficient recognition that we are in a different investing environment. As a consequence, these standard approaches need to be used to a greater extent to cope with the changing investing environment:

1. Shorten Maturities of Fixed Coupon Maturities: If one does nothing else, shorten maturities on fixed coupon instruments. Keep maturities under ten years, better under seven-year, to preserve capital. If you have a 20 year+bond, you will have the unpleasant choice of selling at a loss to recover capital to redeploy or else sit there with a record low, submarket return for an extended period. With shorter maturities, one does collect a below market coupon, but that time period is shorter and you will be able to recover the full value of your instrument to reinvest at those future, higher rates. Yes, long-term U.S. Treasury bonds are safe in regards to default risk, but the very low coupon U.S. Treasury bonds create a greater interest rate risk for investors even if default risk is near zero ( and ditto for municipals). If you need the security of U.S Treasury debt or municipal bonds, select shorter maturities to protect your capital.

2. Ladder!: In addition to shortening the period of the longest maturities held, ladder maturities so that one can take advantage of increasing rates with routine re-investments at ever higher rates. Laddering will also ensure that only a limited amount of investment is made at the longer maturity boundary and will provide regular redemptions which can be reinvested, again at presumptively higher rates. Most investors have heard about laddering maturities but are they using this approach with discipline? In many cases, I believe not, given the complacency in the market. If not, I believe now would be the absolutely best time to begin to use it with discipline.

3. Move Increments of the Portfolio from Fixed Coupon to Variable Rate Investments: As fixed coupon instruments mature (or if one sells an increment of long-maturity investments to redeploy), reinvest proceeds in investments that are levered to variable, not fixed coupon, rates. These would include closed-end bank loan/loan participation funds, variable rate preferreds issued by major U.S. banks, or commercial mortgage real estate equities, depending upon your risk tolerance/aversion. While default risk may be incrementally higher for bank loan closed-end funds or variable rate preferreds, IMHO, the drastically reduced interest rate risk offsets the incrementally higher default risk.

4. Reconsider Your Balance of Default and Interest Rate Risk: With a secular declining rate structure, it is a “no-brainer” to pick avoiding default risk over interest rate risk as the risk from capital impairment within a secular period of interest rate declines is very low; indeed, the risk may be a “negative” risk as one could secure capital gains on bonds over time if sold as the coupon exceeds benchmark rates. However, at a point where interest rates turn higher, the very low current coupon rates extent create a risk that even a small increase in the benchmark rate can really impair the market value of very long (e.g., 20+ years) maturity bonds. This impairment will be significantly greater than any default risk on bank loans or the variable rate preferred shares for major U.S. financial institutions. One does not need to migrate 100% of funds from fixed coupon to variable rate securities (many of which are slightly more vulnerable to default risk); rather, a movement of some funds from fixed coupon to variable rate will provide a capital-conserving hedge against “being all in on interest rate risk” at a time when secular interest rate movements stop going down and start going up.

What I am Doing with My Retirement Income Fund

Mr. Dirk Leach has been running a series on “If I were Starting an Income Fund Today” (latest version found here). In my case, I can use the same title without the “If” as I am building an income fund from which I will be deriving future income (after retirement) and as a core fund into which additional, required 401K payments will be placed (to continue to grow income).

Mr. Leach’s fund is focused heavily on equities to generate income. In my case, I am using fewer equities and a much larger percentage of credit instruments to generate the income (for the reasons cited above), with the core funds consisting of:

Fund Name

Type of Fund or Asset

Eaton Vance Senior Income Trust (NYSE:EVF)

Bank Loan Participation CEF

Nuveen Credit Strategies Income Fund (NYSE:JQC)

Bank Loan Participation CEF

Claymore Inflation-Linked Income (NYSE:WIA)

Inflation-lined Fixed Coupon

Powershares Variable Rate Preferred Shr (NYSEARCA:VRP)

Variable Rate Preferred ETF

Prudential Short-Duration High Yield (NYSE:ISD)

Short-duration High Yield

I have begun adding other securities to this core set of investments. One overlap with Mr. Leach, also one of his selections, was the addition of Starwood Property Trust (NYSE:STWD), a commercial real estate lender whose portfolio is significantly levered to variable rates, consistent with the general recommendations made above.

I use these securities as examples, not specific recommendations, as I have been building this income portfolio over the past half year. These securities may not be as instantaneously attractive as they appeared (based upon holdings, yield and discount to NAV) as when I bought them and I might choose now other securities (but of the same ilk) if I were buying them today. More recently, I made a different selection of an Eaton Vance CEF (EVF) for a family member. I do want to own funds from highly capable fund managers and limit myself to selecting from their fund options.

My purpose in this article was to propose a strategic approach to adapt to a new environment, not necessarily recommend specific securities per se. In selecting specific securities, there are a number of Seeking Alpha contributors from whom you can secure thoughtful recommendations. Many have investing styles contrasting with mine (and each other). Top-of-mind examples include the above-mentioned Dirk Leach (example cited above), Darren McCammon & the Cash Flow Kingdom (recent article here), Colorado Wealth (example here), Achilles Research (example here), Richard Lejeune (example for a security that I own in my risk portfolio here), BDC Buzz (who focuses on Business Development Companies, which are nonetheless largely levered to variable rates, with a selected example here), Double Dividend Stocks (example here), Norman Roberts (example here), Blue Harbinger (found here) and the ever-meticulous Scott Kennedy (found here), who does incredibly careful, detailed analysis. There are many other excellent analysts writing within the SA community, but these are among the writers that I follow most closely. Selecting securities meeting the criteria that we have discussed from a variety of investing styles may provide an increment of additional diversification that one will not get from accepting recommendations from one writer (having one style).

Summary & Conclusions

With interest rates near truly historic lows, we stand at one extreme of the historic distribution of interest rates spanning four hundred years. While anything can happen, it seems much more likely that we will move towards the mean rather than continuing to move away from the mean over the intermediate to long-term. As such, I believe that it is prudent to adopt investing strategies designed for declining-rate environments, with which most investors are very comfortable and view as immutable truths, to those adapted to a completely different environment where different strategies will be rewarded over the long-run (and the previous regime of strategies will be severely punished).

Given the substantial difference in rates between average rates and current rates, substantial market value/capital losses in those fixed coupon, “riskless” credit securities will be incurred upon reversion to mean rates. Indeed, given the current low coupons offered, substantial losses will be incurred even as rates begin to mean revert (and with increased recognition of a change in environment, given the market’s tendency for anticipation).

Some things you can only see in retrospect. Some time was needed to secure enough market data to determine that we are likely at the turn of the rate cycle. However, waiting longer to make absolutely sure that we are at the turn of interest rates and failing to adapt to a fundamentally different environment, with which most readers are unfamiliar, will not provide enhanced security of capital; rather, it is more likely to result in regret.

Unfortunately, this will also only be known for certain in retrospect.

(Data obtained from U.S. Treasury, St. Louis Federal Reserve Board, Bank of England, Yahoo Finance and Google Finance websites)

No guarantees or representations are made. The Owl is not a registered investment advisor and does not provide specific investment advice. The information is for informational purposes only. You should always consult an investment advisor.

Disclosure: I am/we are long STWD, JQC, EVF, WIA, ISD, VRP.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.