Season Investments

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Bonds in Bondage

Posted on September 27, 2016

“It’s time to rethink the role of U.S. Treasuries in portfolios.” - Richard Turnill, BlackRock’s Global Chief Investment Strategist

2016-09-27_bondage.jpgAs investment advisors our job is to help our clients flesh out their objectives, risks and constraints, and then to construct a long-term investment plan to achieve success over time. This process is ongoing and fluid, but it is always guided by an Investment Policy Statement that lays out strategic asset allocation targets for the portfolio. Once a broad allocation is established, we then manage assets within those boundaries in an effort to maximize efficiency and deliver strong risk-adjusted returns.

As readers of this blog may have noticed, bonds are an asset class that we have been giving a lot of thought to lately. Bonds are in bondage to the low rates created by loose monetary policy, and the question of what to do about it is one of the more frequent ones we field in client meetings.

As the chart below shows, bonds (as measured by the 10-Year Treasury in this case) have historically been a very attractive investment, producing moderate rates of return with relatively low volatility and drawdowns. Additionally, they have acted as the yin to the stock market’s yang making them fantastic portfolio diversifiers.

2016-09-27_10y_cum_ret.png

But despite a bright past, the future of this asset class looks a bit more cloudy. Remember that bond prices move inversely with yields, meaning that prices must fall in order to push yields higher. A common measure of a bond’s sensitivity to an increase in rates is Modified Duration*, or simply “duration” for our purposes. In simple terms a bond’s duration is the measure of its expected price movement in the face of a 1% move in yields. The 10-Year Treasury bond, for instance, has a duration of 9.1 which means its price is expected to move roughly 9.1% for every 1% change in interest rates. The longer a bond’s maturity the larger its duration, and the larger its duration the more sensitive it is to changes in interest rates.

Let’s take another look at that bond chart. This time we’ve overlayed the yield on top of the cumulative return chart. As you can see, yields have declined steadily over the past 30 years. In addition to regular coupon payments, bond investors have been nourished by a steady diet of price appreciation over this time period – to the tune of roughly 1.5% a year for thirty years!

2016-09-27_10y_cum_ret_w_yld.png

Given the secular trend towards lower interest rates over the past three decades, we have to make adjustments to our expected returns for bonds going forward. Expecting history to repeat itself would be downright foolish. Is it possible for yields to go even lower from here? Sure it is, and in fact they could even dip into negative territory as we discussed a few weeks ago in NIRP Is The New ZIRP. But clearly there is less chance of price appreciation when the starting point is 1.5% instead of nearly 10.0%, and there is certainly a lot more risk in taking that bet.

This dynamic was explored in a recent commentary from BlackRock entitled Rethinking The Role Of Treasuries. Global Chief Investment Strategist Richard Turnill first identifies the diminishing diversification benefit from bonds in this low yield environment,

…bonds tend to have higher correlations to stocks during periods when markets are concerned about Fed tightening, damaging their traditional role as portfolio diversifiers.

He later points out that there is a very small margin of safety for bond investors buying in at these low yields,

Depressed yields mean there is currently little safety cushion for holders of U.S. government bonds. Just a 0.2 percentage point increase in Treasury yields could wipe out a whole year’s worth of yield income. It’s time to rethink the role of U.S. Treasuries in portfolios, and specifically to be cautious of long-duration Treasuries. The risk-reward landscape for long-duration Treasuries is shifting.

 We have been considering the implications of all this in our portfolio allocations. On one hand, we’d like to hold Treasuries as a classic hedge against negative economic or financial shock. But depending on what form that shock takes they might not hedge risk at all, and in fact several of the stiffest stock market corrections in recent years have corresponded with plummeting bond prices as well. Additionally, the standalone risk/return tradeoff in bonds is just flat out unattractive. Even if the US enters a recession, where are yields supposed to go from here? In our estimation the risk of rising rates far outweighs the potential benefit of falling rates in a hypothetical “risk off” scenario.

There are several things we are doing in response to all of this:

  • We are deemphasizing bonds across the board. At some point in the future, when rates are higher, we will once again allow them to occupy more space in our portfolios.
  • We are finding alternative sources of income. Understanding the risk side of this equation is critical, but we are finding good opportunities in marketplace lending and hard money lending.
  • Within our publicly traded bond allocations we are reducing our exposure to interest rate risk and focusing mostly on unconstrained bond managers that can actively pursue opportunities across global fixed income markets without being tied just to corporates and Treasuries.

As we’ve said in the past there is no silver bullet to the lack of high yielding investment opportunities in today’s environment. That said, investors need not feel like they have to remain in bondage to the bond market. We are working hard to uncover investment opportunities that will produce desired long-term returns without unnecessarily increasing the portfolio’s risk profile, and we’re confident these efforts will pay off in spades when rates eventually begin their next secular uptrend.


*Modified duration is very similar to Macauley Duration which is the weighted average term to maturity of a bond’s expected cash flows. The difference between the two is nuanced and is beyond the scope of this post.


david_headshot_bw.jpgAuthor David Houle, CFA is a founding member of Season Investments. He serves as the firm's Chief Compliance Officer as well as sitting on the investment committee overseeing the management of client assets. David spent nearly ten years in various roles primarily managing individual client assets prior to co-founding Season Investments. David graduated with a degree in Finance from Colorado University in Colorado Springs in 2003 and earned the Chartered Financial Analyst (CFA) designation in 2006. David and his wife Mandy have three children and spend most of their free time with friends and family.


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Transparency is one of the defining characteristics of our firm. As such, it is our goal to communicate with our clients frequently and in a straightforward way about what we are doing in their portfolios and why. This information is not to be construed as an offer to sell or the solicitation of an offer to buy any securities. It represents only the opinions of Season Investments. Any views expressed are provided for informational purposes only and should not be construed as an offer, an endorsement, or inducement to invest.