In an environment with historically low interest rates, fixed income investors
have been pouring money into longer-duration securities, substituting three-
and six-month Treasury Bills with 10-year Treasuries or bond funds.
To an extent, this should not be so surprising: the Federal Reserve's
extraordinary monetary policies have resulted in extremely low yields at the
short end of the yield curve. Investors seeking yield have been forced out the
yield curve or into increasingly risky investments in an attempt to gain higher
investment returns.
However, this is not a strategy without risks, both at the individual investor
level and for the economy as a whole. Are the Fed's
monetary policies, combined with the government's decision to issue increasing
levels of longer duration debt, having the unintended consequence of stoking
the fire for further financial stress?
While many observers focus on the increased risks associated with moving into
lower-quality, higher-yielding instruments, and away from the likes of
government securities, often overlooked is the increased risk associated with
simply moving out along the yield curve.
Fixed-income investments become ever more risky the further out the yield curve
investors move. Moving from the short end of the curve into similar-quality
fixed-income securities at the longer end of the curve may have a marked impact
on the overall risk profile of a portfolio, as we will explain in more detail
below. Of course, increasing the exposure to lower-quality fixed-income
securities also implicitly raises an investment portfolio's risk profile, and
should be a key consideration before any such decision is made.
Longer duration fixed-income securities may have a greater propensity to cause
"black swan" type events, given that they historically display fat-tail return
distributions and much higher levels of price volatility relative to
shorter-duration securities. We are most concerned that the aggregate risk
profile of many fixed-income investments, and especially those underlying
future obligations, may have now increased.
The implications could be potentially disastrous: the likelihood of another
financial catastrophe may have risen; many investments that everyday Americans
are relying upon to provide future financial security may have been put in
jeopardy. Now may be the time for investors to consider fixed-income
investments at the short-end of the yield curve to take advantage of the
diversification benefits fixed-income investing may offer, while seeking to
mitigate interest risk. Investing outside of the US dollar may also prove
beneficial, should present dynamics negatively affect US economic stability.
Recent US Treasury data tells an interesting story. Over the 12 months through
March 31, 2010, the level of T-Bills held by the public fell 9.4%, whereas
Treasury notes and Treasury bonds held by the public increased by 48.0% and
22.9%, respectively. In just one year, the average length of marketable public
debt held by private investors has increased by seven months: from three years,
11 months to four years, six months. [1]
There has been a dramatic shift in the term structure of interest rates, as
evidenced by changes to the yield curve:
To a large extent, the changes in public Treasury holdings has been driven by
the federal government's choice to issue greater levels of longer duration
securities. However, the story that these statistics, in concert with the yield
curve, paint is very important: for there to be a decrease in the yield of
longer duration securities (as depicted above), which infers an increase in
price, there would require greater investor demand, all else equal.
But all things have not been equal: the government has issued vast amounts of
longer duration notes and bonds, increasing the supply of these same longer
duration instruments. When the supply of any security increases, with no
increase in demand, the net effect should be an increase in the yield (decrease
in price), but the opposite has happened.
By implication, these dynamics infer that the level of demand for longer
duration fixed income securities has outstripped the increase in supply;
investor preference has shifted to longer-dated securities.
Another important observation is that the opposite has happened at the short
end of the curve: the government has reduced the level of T-bills outstanding
(reduced supply), yet yields have increased (prices have fallen), implying that
the demand for T-bills has fallen more sharply than the decrease in supply. The
market has actively shifted out of the short end of the yield curve and into
the long end.
These trends are also evident in traditional measures of short-duration
investments. We have witnessed a reduction in both retail and institutional
money fund assets, along with a reduction in large time deposits held at
financial institutions:
Of course, increased perceived risks associated with money market funds,
brought about by the Reserve Primary Fund "breaking the buck" in 2008, reducing
its net asset value to below $1 due to Lehman Brothers' bankruptcy filing, may
have acted as a catalyst for some investors to redeploy funds further out the
curve or into other asset classes. In our opinion, investors may be jumping
from the frying pan into the fire.
It is widely acknowledged that longer duration fixed income securities are more
susceptible to interest rate risk than shorter duration securities. What is
less well known is that longer duration securities exhibit much larger, more
frequent movements in price than a normal "bell-shaped" curve would suggest and
may therefore be more prone to causing black swan type events. Investors don't
even need to consider an extreme (albeit possible) future scenario, such as the
Chinese or Japanese authorities dumping their US debt holdings, for this to
occur. Just consider the historic underlying attributes of the 10-year
Treasury:
The annualized price volatility of 10-year Treasuries has historically been
much higher than short-term T-Bills. The following chart depicts price
volatility over two separate timeframes: leading up to the recent financial
crisis (December 31, 1999 - June 30, 2008) and since its onset (June 30, 2008
to June 30, 2010).
Research by the Federal Reserve Bank of St Louis found that 10-year Treasury
prices exhibited much wider tails than would be expected by a normal
distribution, commonly referred to as "fat tails". [2] The research analyzed
the volatility of movements in price of the 10-year Treasury bond over a period
of more than 25 years.
The results indicate that investors may be subject to significant interest rate
and price risk when investing in longer duration securities. It found that
there are 16 times more price changes in excess of 3.5 standard deviations than
expected with a normal distribution. Furthermore, whereas changes in price
greater than 4.5 standard deviations would occur only seven times in a million
under the normal distribution, the findings showed 11 changes in 6,573
observations.
One only needs to look to the recent financial crisis as an example of how
fat-tail events can wreak financial havoc if not properly addressed as part of
a comprehensive approach to risk management, and that is where the problem may
lie.
We remain skeptical that many of those who have moved out along the yield curve
have the sophistication needed to properly manage the increase in risk profile
of their underlying investments. More concerning is that many may be the
institutions in charge of managing assets anticipated to provide future income
streams and financial security for many working class Americans: during the 12
months to March 31, 2010, life insurance companies increased holdings of
Treasury issues by 27.1%, private pension funds increased their holdings by
59.4%, state and local government retirement funds increased holdings by 20.9%.
[3]
Should these institutions fail to meet their objectives, it could potentially
precipitate a massive hit to the US economy and financial system, and a
collapse in the US dollar.
Over this same timeframe, the household sector increased its holdings of
Treasury issues (outside of non-marketable savings bonds) by a whopping 72.8%,
while commercial banks increased their holdings even more, by 115.4%. [4]
Not only may the Fed's policies have contributed to an increase in the risk
profile of investments throughout the economy, but they may also have driven
the prices of long-term bonds towards bubble territory. Moving further and
further out the yield curve appears to have become an evermore-crowded trade.
Should we witness a substantial reversal in sentiment, the risk of large
movements in price may be compounded as many investors scramble to exit their
positions. A significant inflationary shock to the system may prompt such a
reaction - a very real threat in our opinion, given the vast amounts of money
the Fed has been printing.
At some point, the deteriorating public finances of the US government may
eventually force investors to reevaluate the rate at which they are compensated
for holding US debt obligations. The US fiscal situation has deteriorated
significantly, yet the rate the government pays to issue debt has fallen. While
the rest of the world is tightening the hatches, imposing fiscal austerity
measures, there is little evidence of a concerted effort to rein in government
spending on either side of the aisle in the US. If the US fiscal situation
continues to worsen, debt of foreign governments with similar maturities may
become comparatively more attractive.
If and when the dam breaks, many investors could be in for a rude awakening:
this is likely to put upward pressure on rates in the US, causing bond prices
to fall and may put renewed pressure on the US dollar should investors move
money offshore.
There is a high likelihood that the risk profile of commonly considered "safe"
investments - high-quality fixed income - has actually deteriorated on
aggregate, throughout the economy, by virtue of extremely low rates brought
about by the Fed's monetary policies.
In our opinion, investors should be mindful of the potential risks associated
with investing in longer-duration fixed income securities, especially if they
harbor concerns over inflation or rising interest rates globally. As interest
rates rise, fixed-income securities typically fall in value: the longer the
duration of the security, the greater the fall in price.
Investors may want to consider diversifying internationally to protect against
the risk of these scenarios playing out. Many short-maturity international
government debt instruments already pay much higher rates than the very low
rates available at the short end of the curve in the US. Indeed, we have
witnessed many international central banks raising interest rates recently. As
such, investors may want to consider investing in international fixed income at
the short end of the yield curve.
Notes
1. United States Department of the Treasury
2. Federal Reserve Bank of St. Louis Review, March/April 2005, 87(2, Part 1)
pp. 85-91
3. Federal Reserve Board of Governors, Flow of Funds Table L.209
4. Federal Reserve Board of Governors, Flow of Funds Table L.209
Kieran Osborne is co-portfolio manager of the Merk Absolute Return
Currency Fund, part of the Merk Mutual Funds that include the Merk Hard and
Asian Currency Funds. Merk Insights provides the Merk perspective on
currencies, global imbalances, the trade deficit, the socio-economic impact of
the US administration's policies and more. See http://www.merkfunds.com/.
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