Fresk: Bonds At A Crossroad

February 03, 2014

Is the end of 30-year bull market in rates imminent, or are we just in a cyclical bear?

This article is part of a regular series of thought leadership pieces from some of the more influential ETF strategists in the money management industry. Today's article features Clayton Fresk, CFA, portfolio management analyst at Georgia-based Stadion Money Management.

Over the past year, particularly the latter eight months of 2013, there has been increasing market chatter regarding the fear of rising rates and the subsequent end of the 30-year bull market in bonds.

The overwhelming analyst recommendation for 2014 is unfavorable toward the fixed-income asset class. Within the asset class itself, almost everyone is preaching a short-duration/high-spread portfolio, and, in the nearer term, I’m in the same boat.

However, after taking a step back and looking at longer-term data, the question does arise as to whether we truly are at the end of the long-term bull market in rates, or if what the market has experienced over the past 18 months is just a cyclical bear market on a continued lower-rate trajectory.

Below is a chart of 10-year Treasury yields beginning August 1986—the low point in rates after the early-to-mid-1980s decline.

10_Year_Treasury_Yields

Key Points:

  • Rates have remained in a ~2.65 percent trend channel during this long-term decline
  • During the secular bull market in bonds, we experienced six separate cyclical bear markets, notated in red
  • While the recent two bear markets have not seen the same absolute level of rate increase, the (time) duration and total return effect of the climbs have been similar to previous bear markets.

While I don’t normally use Fibonacci retracements in my analysis, a note of interest is that the recent two bear markets have topped out at the 76.4 retracement level within  the trend channel.

Change_In_10_Year_Yields

 

All of this begs the question, Is this time different? Via this analysis, the bear market we’ve seen over the past 17 months doesn’t look significantly different from previous bear markets.

Additionally, stepping back and looking at other asset classes, equities have rallied impressively in the past five years, and some market participants believe that market is now “overcooked” and a pullback in equities is a distinct possibility.

If that’s the case, could we see some flight-to-quality asset rotation back into fixed income, which could increase demand and drive rates lower once again?

Perhaps that’s exactly what we’re seeing as January draws to a close. The S&P 500 has traded more than 3 percent lower, and the yield on the 10-year Treasury note has retreated 30 basis points from the end of the year.

The counterpoint to this question is—very fairly—that this time is different. The current low level of rates might very well be unsustainable.

Additionally, we have factors—such as QE 1, 2 and 3 (quantitative easing—that have created “artificial: demand, and henceforth have instilled a ceiling on rates.

Therefore, as the Fed begins to taper purchases and we see a new chief in position, these may be the necessary catalysts to trigger a continuing rate-climb environment.

Positioning is this type of uncertain environment can prove problematic depending on what side of the higher-rates/lower-rates coin an advisor is on.

If you’re in the lower-rates camp, positioning is much easier, as the number of mid-to-long duration fixed-income ETFs is plentiful. One can step way out the curve into products such as the Pimco 25+ Year Zero Coupon ETF (ZROZ | C-51) or into something more simple/vanilla such as the iShares 7-10 Year Treasury ETF (IEF | A-49).

If you’re in the higher-rates camp and just wish to shorten the duration of your fixed-income holdings, nearly every one of the fixed-income sectors now has short-duration options available, including new funds such as the ProShares Short Term USD Emerging Markets Bond ETF (EMSH).

What may be of more interest to those who have more conviction in their higher-rates view is the new negative-duration ETFs offered by WisdomTree: the WisdomTree Barclays U.S. Aggregate Bond Negative Duration Fund (AGND) and the WisdomTree BofA Merrill Lynch High Yield Bond Negative Duration Fund (HYND). These funds combine a long position in standard index exposure along with short futures positions to generate the-negative duration exposure.

 

To illustrate, AGND targets a negative five duration, and as the long side of the portfolio (the Barclays US Aggregate) is approximately a positive six-year duration, the short futures pair off and run at an approximate negative 11-year duration (using a combination of long-dated futures).

The resulting key rate duration exposure is as follows:

AGND_Rate_Duration_Exposure

The result is a portfolio that targets a short position primarily in the 10- to 20-year part of the curve, with a small degree of a curve-flattener position (about a 1.3-year long exposure to five years and in, while being short seven-year rates and 30-year rates to offset).

While this positioning could be a little aggressive for some advisors, an option to temper the negative-duration exposure would be to pair the negative-duration ETF with the similar zero-duration offerings in AGZD and HYZD. While similar in construction, these ETFs use shorter-dated futures to create a zero- (rather than negative-) duration portfolio.

The following shows the effect of using a 50/50 AGND/AGZD portfolio:

AGND_AGZD_50_50_Comparison

While the long side of the portfolio continues to be the Barclays US Aggregate, this blended portfolio tempers the duration exposure to a negative 2.5 years. This also negates some of the curve-flattener exposure, keeping it to a purer short-duration exposure.

Lastly, for advisors who do not have a strong viewpoint as to where rates are headed, being tactical in the portfolio may be the best option.

Having the flexibility to move toward long or short duration, long or short spread, or alternative sources of income in an uncertain market may prove more beneficial over trying to predict what will happen and either taking undue risk in an allocation or missing potential opportunities.


Founded in 1993, Stadion Money Management is a privately owned money management firm based near Athens, Ga. Via its unique approach and suite of nontraditional strategies with a defensive bias, Stadion seeks to help investors—through advisors or retirement plans—protect and grow their “serious money.” Contact Stadion at 800-222-7636 or www.stadionmoney.com.

References to specific securities or market indexes are not intended as specific investment advice.

 

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