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Monday, July 1, 2013

Bond Market Review Q2 2013

Bond Market Review 2 Q 2013

Regardless of whether or not it was a misreading or overreaction to Fed Chairman to Ben Bernanke’s recent comments on future interest rate policy, it seems clear that the market (finally) is reacting to the reality that historically low interest rates cannot go on forever. It was as if the market in both bonds and equity markets (to be reviewed in a separate article )suddenly realized that the leveraged, long term bond and other “reaching for yield “ positions are  subject to very high risk in a rising rate environment. In a game of musical chairs those bond market participants that planned to hold on to positions that would be adversely affected by higher rates held on to the last minute and then scrambled at the same time to grab a chair in the circle of those unwinding before the other guys did.
Every cycle of market unwinding of positions and reversal of trend generates more and more volatile short term moves then the previous one. As 10 year treasury interest rates rose  1.7 to 2.6%  since May 1. Remember that  a 1% change in interest rates on a 10 year bond creates a 10% decline in price of the bond.  An overreaction ? perhaps. But when the losses pile up particularly with leverage and individual investors that never knew losses on bonds or bond funds could happen so rapidly, there was far more overreacting and selling  than holding on or attempting to trade the opposite way of the market move.

Here are the moves in rates over the past year…note the large move since only May 1.

All of a sudden market observers who were intent on lengthening maturities to pick up yield are looking at graphs like this (below)  this . Instead of talking about low rates for the foreseeable future those same analysts are talking of markets returning to a long term average of 4% or higher on longer term rates. And we can pretty much be sure the move will be violent and volatile as it occurs.

Such a move to higher rates by the Fed may not happened in a year or even two but finally it seems that the market is realizing the downside potential for interest rates is far greater than the potential upside. The result a violent move up interest rates/down in price for bonds particularly longer term one.
Many months ago I have written about  shifting allocations to shorter maturities with a “barbell strategy” in credit making a mixture of short term low risk government and investment grade bonds with higher credit risk in short term high yield bonds. While nothing was immune from the bond selloff the strategy held up rather well . And as the year progresses the short term bond funds will pay higher dividends benefitting from rising rates and offsetting declines in price.
Here is the quarterly total return for the short term ETFs it does not include dividends which will be paid out on some of these instruments after quarter end.
Short term bond etfs for the second quarter:
Sjnk and HYLD short term High Yield
VCSH short term investment grade corporate bonds
VCGH  Short Term Governent Bonds Returns top volatility below.

As one can see from the chart high yield investors were rewarded for taking the credit risk despite all the talk in the press about massive selloff in high yield bonds. In fact the declines in bonds were all about the maturity and not about the credit risk. The short term credit barbell in short term bonds showed it’s advantage even in a very ugly bond market. The losses in intermediate bonds were twice that of short term bonds and if you look at the bottom chart the long term bonds generated losses 6 times as large as the short term bonds.
By comparison here(below) are the intermediate term ETFs JNK and HYG high yield VCIT investment grade corporate bonds and vgit for short term government bonds. Even here high yield investors were “rewarded” for taking more credit risk…at least relative to investment grade corporate bonds. The large decline in corporate investment grade bonds relative  to lower risk treasuries and high yield probably falls in the category of an anomaly that aggressive traders might look to take advantage of.

And the long term bond etf VGLT for government bonds and VCLT for investment grade corporate bonds looks really even worse in their quarterly returns (there is no long term high yield ETF Here it is easy to see that although the media was writing about the big fall in corporate bond prices , the move was about duration not credit quality…owning treasuries instead of corporate bonds woudnt have helped much. 

An area of the bond market that I have been warning about in my blog for months is emerging market bonds. This is an area where the incremental yield over treasuries of 3% (about the same as high yield) was clearly-- at least to me-- not worth the incremental risk of currency movements and political risk. Add to that the fact that the countries borrowing in the bond market are the weakest countries in the emerging markets. The strongest economies need not issue bonds. And despite the beating emerging market stocks took at least there is a balanced risk return: interest rates can only create a finite capital gain from falls in interest rates and both stocks and bonds are subject to currency risk and political risk. Yet stocks have no limits on the upside even if downside risk is similar.
How much the large selloff in emerging market bonds carried over to emerging market stocks despite their long term different risk/reward will be examined in the equity market review.
Here are the returns for some  emerging market bond etfs the worst performers were in local currency debt but the dollar denominated bonds didn’t do that much better. For instance EMLC is bonds denominated in local currency , EMB denominated in dollars.


It wasn’t surprising to see these flows in emerging market bond funds note the low valuation in emerging market stocks that has occurred as this has happened.

Going forward:
 Remaining in shorter durations and some higher credit risk  in 2012 and were largely shielded from the major selloff in the bond market. I see no reason to  this approach doesn’t seem attractive  going  forward except with some minor adjustments across credit quality (high yield, investment grade corporates and governments)
. The HYLD and SJNK short term ETFs have shown how they behave in a large market selloff. They both showed near identical price performance yet the hyld carries twice the yield making HYLD superior in terms of risk return appropriate adjustments have been made between the two instruments. Adjustments should be considered made accordingly.
The preferred approach for a long term investor  Is not to make large portfolio changes to short term market developments. Thus the question of whether the bond market “overreacted” to Chairman Bernankes recent statements and there will be a bit of a recovery in the bond market should be irrelevant to long term strategy

The poor risk reward of long duration bonds was clear for along  time yet many markets held on to squeeze out the short term profits..Portolios  that have been overwhelming in short duration bonds in anticipation of this type of move have now shown their value...

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