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Bond Strategy


Managers of investment portfolios are concerned about risk, return, and the level of risk required to achieve a specific desired return. In the pursuit of returns, history and theory confirm that the expected return on equities (stocks) exceeds the expected return on fixed income (bonds). That’s why investment managers looking for superior inflation-adjusted returns begin with equities. They spread the risk among domestic and foreign equities, large companies and small companies, and growth and value stocks. Yet even a highly diversified equity portfolio may have higher risk than is desired by the investor. The primary reason for adding fixed income is to reduce this risk, or volatility.


Two risk factors determine the expected returns of fixed income securities: the credit rating and the term to maturity. The credit factor is a gauge for default risk, while the term factor is a gauge for a bond’s price sensitivity to unexpected changes in interest rates. These two factors explain most of the variation in bond returns. The challenge for investors is to structure their allocation to fixed income securities in ways that target credit and term factors intelligently and cost efficiently.


One approach is to maintain constant exposure to credit and term spreads over time, regardless of whether the expected returns for these factors are high or low. This approach ignores the the market-based information in prices.


A second approach is to forecast changes in yield curves to determine how much term and credit risk one should have at any particular point in time. The difficulty with this approach is that it’s almost impossible to forecast changes in economic and market conditions with enough consistency to produce good results.


As a variation on the forecasting approach, an investor may attempt to predict changes in credit ratings for issuers before they are priced by the market, then over- or under-weight the issues whose ratings are about to change. Like stock picking, this approach is risky and unlikely to add any value consistently.


A third approach is to use the information contained in market prices to determine how much credit or term risk to take as the yield curve and yield spreads fluctuate.


The Maturity Decision


Most investors recognize that short-term fixed income strategies are less volatile than long term fixed income strategies. The difference in standard deviations between short-term securities (like treasury bills) and long-term securities (like 20-year Treasury Bonds) is startling (Table 1).


Table 1: 

Standard Deviations

 

Annualized - Qrtly Data

 

(01/64 -12/10)

One Month T-Bills

1.42

6 Month U.S. T-Bill

1.77

ML 1 Year US Treasury

2.34

5 Year T Notes

6.21

20 Year Gov't Bonds

11.29


Short-term bonds also have a lower correlation with equity portfolios than do long-term bonds (see Table 2). Thus, while you reduce re-investment risk when you extend the maturity, you increase the price risk of the fixed income assets and you also increase the overall risk of the portfolio. The evidence is strong if risk reduction is the primary goal, that short-term is more effective than long-term fixed income.


Table 2: 

Correlation

Correlation

Maturity

With S&P 500

With EAFE

 

(01/64 -12/10)

(1/ 70 – 12/10)

One Month T-Bills  

-0.002

-0.067

6 Month U.S. T-Bills

0.026

-0.042

ML 1 Year US T-Bills

0.035

-0.034

5 Year T Notes   

0.086

0.032

20 Year Gov't Bonds

0.119

0.054


Yet long-term bonds still fill many investment portfolios. Many investors hold long-bonds in the hope of higher returns. There is often the intuition that long–term bonds must have higher expected returns than their short-term counterparts. Historically, that has not been the case (see Table 3). The data shows there has not been a reliable return premium for extending maturities into longer bonds.


Table 3:

Risk/Reward: Does it Pay to Extend Maturities?

Quarterly Data

(1/61-12/10)

1-M U.S.

T-Bills

6-M U.S.

T-Bills

1-Yr U.S

T-Bills

5-Yr U.S.

T Notes

20-Yr U.S.

Gov't

Ann Comp Ret.

5.45

6.2

6.41

7.27

7.37

Ann Std Dev

1.42

1.77

2.34

6.21

11.29


Yet the data from the period 1982 through 1992 shows a tremendous premium for maturity extensions. In this period, long-term bond returns were more than double the returns of short-term bonds, and almost kept pace with the return of the stock market (see table 4).


Table 4: 

Annualized Ret (%)

Maturity

Qrtly Data

 

(01/82 – 12/93)

One Month  T-Bills

6.89

6 Month   U.S. T-Bills

8.09

1 Year  US T-Bills

8.73

5 Year T Notes

12.45

Long Term Gov't Bonds

15.26

S&P 500

16.09


However, a longer perspective would indicate this outcome was more the exception than the norm. In data going back to 1926, there is no other period for bonds like the bull market of the 1980’s. Long-term interest rates declined from 15% to 7%. But in the five years preceding 1982, interest rates climbed from 7% to 15% and long-term bond returns trailed the returns on Six-Month Treasury Bills by 7.86% per annum (see Table 5). When the entire interest cycle is considered (Table 3), return premiums for long-term bonds disappear. Historical evidence shows that for taxable bonds, on average, investors have not been rewarded for extending maturities beyond 5-7 years.


Table 5:

Annualized Ret (%)

Maturity

Qrtly Data

 

(1/76 – 12/81)

One Month U.S. T-Bills

8.91

6 Month U.S. T-Bill

9.58

ML 1 Year  U.S. T-Bills

8.54

5 Year T Notes

5.79

Long Term Gov't Bonds

1.72


Interest Rate Forecasting


With no reliable term premium, managers with the ability to forecast interest rates stand to profit more from by using long-term fixed income securities when their forecast calls for declining interest rates. The question naturally follows: Can investment managers reliably forecast interest rates?


Bond market efficiency, like stock market efficiency, has been the subject of many studies. The conclusions are similar: the bond market is highly efficient. Bond prices, and therefore their yields, reflect all available information and follow the classic “random walk” pattern. There is no reliable method of forecasting future bond prices and their interest rates. When properly categorized, actively managed bond funds underperform relevant indexes. Under-performance is approximately equal to the fund expenses. Before fees, bond funds on average perform on par with their appropriate index.


Term Spreads and Returns


Controlling for credit exposure, longer term securities typically have higher average returns and higher risk than shorter term securities. Professor Eugene Fama (University of Chicago) recognized that the bond market is highly efficient and demonstrated that investors may be able to increase their risk-adjusted fixed income returns with a variable maturity strategy that shifts the maturity target of a bond portfolio as the yield curve changes. This creates the possibility for lower risk and higher expected return outcomes. Although the average yield curve is typically upward sloping, this is not always the case. The variable approach would shorten the term risk in inverted yield curves.


The variable maturity approach does not anticipate changes in the yield curve; rather, it seeks to take advantage of opportunities present in the current curve. The cornerstone of the approach is efficient market theory. In an efficient market, the best estimate of future bond prices/yields is simply today’s price/yield. Fama’s research does not mean that the yield curve won’t change. It means that the changes are unpredictable.


The objective of the variable maturity strategy is than to take what is offered by the current yield curve because there is a reliable relationship between term risk and future return spreads. In broad terms, this means shortening maturities in inverted curves and extending maturities in upwardly sloped curves. With this approach there is no need to attempt to forecast the future shape of the yield curve to position a portfolio along the term spectrum. The best indicator of tomorrow’s yield curves is today’s yield curve. Thus, by extending maturities until the point where the yield curve is no longer upward sloping investors position themselves for the highest returns.


It must also be noted that this approach—extending maturities as long as the yield curve is positively sloped— also results in greater investment risk. A best practice is to establish a minimum incremental yield for each additional year of maturity as compensation for additional risk. For taxable investors, a suggested hurdle could be 20 basis points or 15 basis points for municipal bonds. However, if the yield curve is very flat or even negatively sloped, this rule of thumb will lead to the creation of a portfolio that is very short-term in nature. The result will be a portfolio with little price risk, but with great reinvestment risk. For investors using a laddered approach (discussed below) having a minimum and maximum weighted average maturity in the portfolio is useful.


Credit Spreads and Returns


There is a positive relationship between credit risk, as measured by credit ratings, and average returns. Returns and volatility tend to increase in order from the safest securities (US Treasuries) to the riskiest ones (BBB securities). Table 6 shows the spread between intermediate credit and intermediate government bonds, as well as the average spread between those types of bonds.


Table  6:

Credit Premiums in Bond Returns (1/73 – 12/10)

Annualized

Treasury

Gov’t

AAA

AA

A

BBB

Average Return

7.45

7.49

7.72

7.90

8.06

8.71

Compound Return

7.61

7.65

7.88

8.06

8.21

8.90

Standard Deviation

4.25

4.26

4.65

4.94

5.14

5.61

Source: Barclays Capital Intermediate Indices


What causes spreads to change? One possibility is that changes in yield spreads are due to changes in default probabilities of corporate bonds. Another theory is that changes in yield spreads are due to changes in investors’ risk aversion. Most likely both factors are at play. Simple regression studies show that there is a very strong and reliable relationship between current credit/government yield differences and future credit/government return differences. Because the relationship between current spreads and future returns is strong and reliable, we can use the information contained in current credit spreads to structure fixed income strategies with variable credit exposure. If spreads are wider than a given threshold, we increase the allocation to corporate bonds. If they are narrower and do not satisfy the investor’s trade-off, we increase the allocation to government bonds. Of course spreads can always become wider or narrower, increasing expected returns and even producing a capital loss, but this not something we can predict.


Combining Variable Maturity and Variable Credit Startegy


By using the information in credit spreads, we can dynamically vary the allocation between government and corporate bonds and increase exposure to credit risk when credit premiums are expected to be high. And we can use the information in corporate and government yield curves to vary the maturity of the strategy when that risk is likely to pay off. Because there is statistical uncertainty about yield spreads and future return differences, we can also impose credit and term constraints to limit risk exposure. This effectively addresses investor concerns about liquidity and credit or term exposure.