Over the past several months, we have talked a great deal about how falling interest rates
have altered the risk-return trade-offs within the bond market. Over the last several years, falling rates have not only lowered the potential income cushion, but also increased the degree of sensitivity to changes in interest rates. In 1994, the Barclays U.S. Aggregate Index (Agg)
offered a yield
of 5.87% and duration
of 4.78 years. Today, the Agg has a yield of 2.20% and duration of 5.5 years.1
That’s a 3.67% decrease in cushion to protect against an even greater sensitivity to interest rate risk
. As a result, losses from rising rates could have the potential to be more severe on a total return basis as the Federal Reserve (Fed)
begins to normalize policy in the coming months. In response to this risk, many investors have flooded into the short end of the yield curve
in an effort to reduce risk in their portfolios. However, we believe this could be problematic as the Fed begins to shift policy.
The logic of the last year seems well founded: If investors are concerned about rising interest rates, take less interest rate risk. In retrospect, the timing of this trade was too early. Even as the Fed transitioned from tapering
, longer-term interest rates continued to fall. As a result, investors have missed out on income and decreases in rates even after the Fed concluded its tapering program. The yield sacrifice was painful, and being short the benchmark in a falling rate environment never sits well with clients. But with the Fed starting to lose patience with zero interest rates, greater attention should be paid to the risk-return dynamics of the front end of the curve. The bottom line is that income levels are very low, possibly too low, to provide adequate protection if the Fed tightens earlier or more aggressively than anticipated by the market.
What’s Past Is Prologue
In order to understand the likely market reaction to a shift in Fed policy, we examine the three previous tightening cycles to understand how the market reacted six months prior to a Fed rate hike and after. A quick comparison of current market pricing relative to the past three tightening cycles highlights the relatively low income cushion currently offered by 2-Year Treasuries
• The amount of cushion before the 1994, 1999 and 2004 tightening periods was 6.5x, 7.25x and 2.75x current levels, respectively.
• In previous tightening periods, investors pushed the 2-Year yield even higher in the months preceding the initial hikes to increase that cushion.
As we show in the table below, 2-Year interest rates will adjust well in advance of any change in Fed policy. In fact, comparing the yield six months before a change in policy shows that rates rise by approximately 100 basis points (bp)
, on average. While it could be debated that this rise in yields is also estimation about the terminal level of interest rates, the fact remains that investors seeking safety in the short end of the yield curve will likely be adversely affected by a rise in short-term interest rates.
Yields and Total Returns of 2-Year Treasury Notes during Past Tightening Periods
For definitions of indexes in the chart, visit our glossary.
While the magnitude of the rise in rates is not particularly surprising, one of the most interesting elements of previous tightening cycles is shown in the bottom table. In the previous three tightening cycles, the 2-Year Treasury Index posted positive returns solely due to the level of income cushion.3
Price returns were remarkably similar over these previous tightening cycles, despite their differing lengths of time. However, the key takeaway is that income returns allowed investors to avoid negative total returns. Given that this cushion has largely been diminished in the current environment, we believe it is unlikely investors will be able to avoid losses in short duration fixed income strategies if the Fed is earlier or more aggressive than the market anticipates.
As we illustrate in the chart below, investors should keep in mind that 2012 and 2013 were the two worst performing years for the 2-Year Treasury dating back to 1981.4
In 2012 and 2013, price returns contributed 4 bp and 8 bp to the overall return. The annual price returns for 2004, 2009 and 2014 were
-5.315%, -3.34% and -1.46%, respectively. The corresponding income returns were 5.57%, 5.34% and 2.09%. What will performance look like if the Fed surprises the market? How will investors react to potential negative returns in their short maturity bond funds
2-Yr Treasury Note
While we believe that reducing interest rate risk in front of a change in Fed policy is prudent, focusing singularly on the short end of the yield curve may leave investors disappointed. In our view, a more prudent approach may be to hedge
interest rate risk via zero and negative duration fixed income strategies as opposed to simply shifting to the short end of the curve.
Source: Barclays, as of 12/31/1994 and 2/28/2015, respectively.
Source: Bloomberg, as of 2/28/15.
The inception of the 2- Year U.S. Treasury Bellwether Index
. Source: Barclays, as of 2/28/15.