Fixed Income? Part III.
Jarrod Wilcox, June 7, 2004

Skirting The Storm

Preface

Part I (March 12, 2004) in this three-part series on interest rate risks in 2004 described a scenario of economic imbalances created by a) the shock of increasing productivity within emerging markets that is resulting in increased low-priced imports of goods and services into the US together with b) the stimulative efforts of the Federal Reserve to combat unemployment and prevent deflation that would be painful to debtors.  The symptoms of this scenario have been low short-term interest rates, a weakening dollar, and low inflation despite strong corporate profit recovery and despite a huge government budget deficit.

Part II (April 4, 2004) identified in more detail three troubling imbalances that were asserted to lay up fuel for a possible, though still perhaps unlikely, firestorm of interest rate increases.  The first is a large and growing holding of US debt by foreign countries, particularly by Japan and China.  This appears to be a transient response to current conditions rather than to a long-term faith in the dollar as a reserve currency.  The second imbalance is a historically low relative price of imported oil, combined with the growing energy appetite of developing economies such as China and with increasing difficulty in adding to oil reserves to replace consumption.  The third imbalance is a bubble in housing prices, creating credit risk, combined with an expansion of mortgage-backed securities focused on Fannie Mae and Freddie Mac.  In trying to control their own duration risks, these firms create liquidity risks for much of the bond market.

The purpose of this third column is to outline broad recommendations for appropriate responses to the resulting exposure to increased interest rate risk.  The first section below concerns risk management adjustments that would be justified for investors with above-average exposure to interest-rate risk even if the market has already efficiently incorporated the preceding observations in prices.  If one believes that, even after the substantial recent drops in bond prices since Part II's publication, the markets have not yet fully priced the imbalances described, then the second section is also relevant.

Section 1.  General Reduction in Duration Risk

Shorten Duration

First, within bonds, investors should seek  shorter durations relative to normal positions through both shortening maturities and increasing allocations to Treasury Inflation-Protected Bonds (TIPS), which at least exclude most inflation risk.  It is important to note that inaction will actually result in increased duration and increased volatility as higher interest rates reduce the probability of early calls and mortgage prepayments.

Find Alternative Sources of Relatively Stable Returns

Second, the conservative portion of one's portfolio can be enhanced to include higher stable returns from other sources, so that total allocations to bonds can be reduced without giving up so much income.  One good choice is a fund specializing in floating rate notes and bank loans.  Within the illiquid category, potential vehicles include limited partnership interests in real estate not associated with the housing market, and in developed oil and gas, timber and farmland properties.

Many consultants advise allocating part of the portfolio to hedge funds for this purpose.  I would not exclude consideration of hedge funds, but experience tells me that the entry of thousands of new funds (reputedly there are now 8000 hedge funds available) into this competitive arena will produce a ratio of gross returns to fee far less favorable than in the past.

Consider Constructing A Complementary Fund

Third, the investor should reduce overall interest-rate risk through adding holdings that tend to do well when bonds do poorly.  This includes not only alternative stable sources of return, but diversification tilted toward inflation-sensitive stocks or possibly publicly traded oil and gas or mineral trusts.  One can also invest in ETF’s or mutual funds with concentrations in energy and materials stocks.

Anticipate A Vicious Circle

Fourth, the investor should pre-empt the self-perpetuating nature of the interest rate firestorm scenario.  This is an event that may well not happen, but if it develops, will have a large impact not predictable from recent bond volatility.  In statistical terms, the distribution of probabilities for returns has “fat tails,” with a non-normal possibility of extreme results.  In theory, one can maintain a small position in out-of-the money puts on long-term Treasury futures traded on the Chicago Board of Trade.  In practice, there are partial alternatives.

You can reduce any concentration on Fannie Mae and Freddie Mac agency bonds, as well as long Treasury bonds.  I do not believe one can otherwise escape the additional problems conventional mortgage-backed bonds near prepayment points raise in an interest rate spike.  Their return distribution is negatively skewed, with many modest gains offset by a few very bad losses.

Also, you can create a homemade, and mild, form of dynamic hedging to produce a put-like response to bond price moves.  That is, when interest rates start to rise, sell enough longer bonds to bring down your duration further.  (There is also the implication that if they go back down again, you must extend it again.)  The analogy to the cost of a put here is the fact that often you will buy high and sell low.  The benefit is that if there is a prolonged interest rate rise, you will tend to limit your losses substantially.  Success here probably depends on creating a paper plan of action ahead of time with only modest protection goals so that there is not too much trading potential.  The trigger can be simply a pre-defined level of bond losses.  This is mainly useful if your trading scale is small -- otherwise you will further destabilize the market and realize poor prices on the way down.

Active Response to Specific Threats

Disclaimer:  This section concerns active responses to the identified imbalances that, although clearly already partially priced now that oil prices are at $40 a barrel and interest rates have jumped, may not yet be fully priced.  As such, it is inherently less reliable than recommendations based on pure adjustment of position to a situation already well-recognized by the market.

The Weak Dollar and Foreign Holdings of US Bonds

If foreigners, especially Japan, become less willing to invest in US bonds, this will further accelerate the weakening of the dollar that has already taken place.  Investors should make sure that they have adequate international diversification.  The easiest avenue is through international stock index funds.  Gold-related securities are another option, although they are currently highly priced.

A weaker dollar also modestly increases the prospects for increased monetary inflation, which would tilt the balance a bit further in the direction of TIPS, as well as increase prospects for commodities as noted below.

The Potential for Rapid Increases in the Price of Oil and Gas

We have already seen a substantial increase in energy prices, but they remain lower in real terms than in the early 1980's.  In addition to the more obvious energy stocks and funds, mutual funds focused on real returns are an option here. 

It is important to profit from this possible rapid inflation in energy prices, because if it comes it is likely to generate higher general price inflation and consequently higher interest rates and lower bond prices, with losses elsewhere in the portfolio.  To visualize this scenario, recall the spikes in energy prices, inflation, and double digit interest rates of 1980.

Havoc Spread By Fannie Mae and Freddie Mac

The center of the mortgage risk potential appears to be the need for Fannie Mae and Freddie Mac to keep their bond duration tightly constrained if interest rates increase and suddenly give many conventional mortgage-backed securities greater duration.  The resulting sales of their longer-maturity bonds can drive down both agency bonds and Treasuries.  The crisis could then become even larger if a sustained increase in interest rates helped trigger a deflation of today’s housing prices, creating default problems.

The danger is not so much a collapse of these two organizations, though that is certainly possible, but of their actions spreading havoc to the bond markets in general, particularly through the contagion of leveraged hedge funds facing liquidity problems.

The investor willing to take an active stance here might also do well to reduce stock, real estate or hedge fund investment in the housing market.

Summary

The intent of this column is not to sound a note of alarm, but to provide recommended directions for sensible prevention of portfolio damage.  Again, the probability of an interest rate crisis is not high.  But it is material enough, and its consequences serious enough, to encourage action by conservative bond-dependent investors above and beyond the normal response to dark clouds on the horizon.