The age of zero interest rates has had a number of intended consequences as well as some unintended ones. Historically low rates are meant to make credit cheap and plentiful to assist the economy in recovering from the Great Recession.
The greatest unintended consequence is likely the complete mispricing of risk in the debt markets. Whether you consider sovereign debt, municipal debt or corporate debt, there is a strong argument that the current level of reward available is not adequately paired with the risk involved. In fact, we would argue that the risk/reward analysis of the debt market is the most mispriced in history. A huge amount of money has sought refuge from risk in the bond markets. Smart money doesn't stay in dumb places forever.
Risk in the debt markets is essentially measured by two types of risk.
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1. The first risk is referred to as “credit risk,” which is really just the risk that the obligor of the debt will have the financial ability to meet the interest and principal payments on a timely basis. This is the risk that rating agencies such as S&P; attempt to gauge with their system of letter ratings. Most of the time, the ratings work well to express the amount of credit risk that is inherent in debt instruments. During periods like 2008, these ratings can become misleading or even debunked. In normal times, you would expect debt instruments that have less risk to offer less reward and those that carry more credit risk to have higher potential returns. A good example of this would be a U.S. Treasury bond that is rated AA would likely yield less than a high-yield bond that is rated CCC. The rationale is that the former has much less risk than the latter. Wise investors want to be paid well for the amount of credit risk they are taking.
2. The second risk in debt investing is referred to as “duration risk” or interest rate risk. This type of risk is that changes in interest rates can have an effect on the value of debt instruments. The term “duration” is merely a measurement of risk that is expressed as a measure of time. Duration can be thought of as a measurement of cash flows of debt securities in relation to the amount of time it takes to recover the investor's principal. Duration measures price fluctuation risk as a result of interest rate movements, not time. The higher a bond's duration risk, the greater its sensitivity to interest rate changes. This risk is real and it can have an oversized bearing on the returns that investors can receive on an investment. Think of it this way: If an investor buys a 2% bond at par and subsequently market yields rise to 3% then the investor's 2% bond would be discounted to yield the current market level of 3%. If an investor owns a mutual fund that has a 10-year duration, it will drop 10% in value if rates rise by ONLY 1%. Some investors might simply hold the bond to maturity to recover the original par but the real loss suffered by the investor is the loss of higher market yields until maturity. We believe that most investors weren't even in the markets the last time interest rates rose.
Many things affect market interest rates. Over the past five years or so, the Federal Reserve has been very active in trying to hold both long-term and short-term rates low. They have used virtually every tool in their toolbox to keep rates lower than any other time in history. They have inflated their balance sheet to well over $4.5 trillion from around $800 million buying bonds, thus injecting new dollars into the system at record rates.
Beyond the Fed's actions to control rates, the biggest determinate of interest rates is price inflation or deflation. Inflation is simply the loss of purchasing power of a currency. Deflation is the increase in purchasing power of a currency. Inflation and interest rates share both a correlated causal relationship over long periods of time. At times of high inflation, higher interest rates are demanded by lenders to cover the lost purchasing power of currency. Periods of disinflation — or deflation — are generally shared with falling or low interest rates as currency purchasing power stabilizes or actually increases. The Fed has been very busy sowing the seeds of inflation, outwardly admitting their desire to raise inflation expectations in the U.S. They are determined to achieve their goals and they have the unlimited tools to continue to pursue their goals. Global central banks are now following the Fed down the road of seeking inflation. Higher inflation will likely produce higher interest rates and thus duration risk is to be at the top of an investor's mind.
The amount of duration risk in the debt markets is incredibly high. In fact, it is so alarmingly high that the Financial Industry Regulatory Authority Inc. published an Investor Alert in March 2013 warning investors about the high levels of duration risk and the potential adverse effect on bond investments.
Investors have been raised to think of bonds as being conservative. There is a litany of financial models that plow larger amounts of the investor's portfolio into debt as the investor becomes closer to retirement. Could this traditional way of thinking be wrong? Could conventional investment wisdom actually be exposing investors to greater risk, rather than less? Why would elevated duration risk matter to investors; simply because bonds have been one of the most popular asset classes since the financial dislocation in 2008 as measured by flow of funds?
The bear markets of the first decade of the 21st century tortured equity investors and quelled their risk appetite. Consequently, they drained money out of equities and stuffed that money into the “less risky” bond markets. That amount of demand did not reduce as rates declined it actually increased. U.S. Treasury debt has been in huge demand as the Fed — as well as global investors — has joined individuals in devouring debt. The result is that we have nearly the highest ownership of any asset class at the same time as we have the lowest interest rates in history.
This situation is eerily familiar to us as we remember a similar mega top in the equity market in the late 1990s. The definition of an asset bubble is record demand for an asset class at a time when the expected return is at the lowest. Put another way, there is a significant mispricing of risk when the potential reward in an asset class is disregarded. In our opinion, that time is close and could have very bad results for investors who don't pay attention to duration risk.
Indicators of this mispricing are everywhere. Asset classes that include everything from U.S. Treasury debt to high yield junk are trading close to all-time low yields. Yet the duration risk of these instruments is at, or near, all-time highs. As the Fed continues to pursue higher inflation and the need for yield increases, the natural expectation is for the flows to reverse toward normalization. At that time, all of the funds that are in bonds — because of the risk adverse nature of the investors — will likely be punished as rates increase. Many folks have been discussing the “Great Rotation” that describes this eventual normalization of asset ownership. It hasn't happened yet, but it likely will.
Of the two risks facing bond investors today, arguably duration risk is close to all-time high levels. This risk is present at the same time as potential reward from those investments is close to all-time lows. Demand for bonds remains close to its highs and prices paid are also close to their highs. This condition is present in most all debt markets globally. The Fed is concluding their asset purchase program, thus removing a key buyer in the market that has helped to provide an environment of low rates. The Fed continues to seek higher inflation expectations which would likely be accompanied by higher interest rates.
Higher interest rates punish bond prices and the returns of those who own them. Risk-adverse investors will likely vote with their feet when rates begin to climb. Instead of being a safe haven from risk it may be more likely that bond investors with large duration risk may be lambs being led to slaughter.
Scott Colyer is chief executive officer and chief investment officer of Advisors Asset Management
