We recently moved our fixed income portfolios to a near zero-risk position. We believe there is the potential for a significant sell off in the bond market – a market many investors consider a safe part of their investment portfolio. The following is our rationale:
RISING INTEREST RATESIn December, the US Federal Reserve raised its benchmark rate by 25 basis points for the first time in nine years, ushering in a new rate-tightening cycle. The last time the Fed raised rates was in July 2006. Following the 2007 debt and housing crisis in the United States, the Fed lowered its rate to zero, where it has been since December 2008.
Given that this has been the longest period of time between rate hikes on record, we are in some ways entering unchartered territory. Historically, rising interest rates have been bad for bond prices – when rates go up, bond prices go down. However, since we are in unchartered territory, we just don’t know how much bond prices can decline.
INCREASED RISK IN BOND FUNDS AND EXCHANGE TRADED FUNDS (ETFs)In this era of very low interest rates, bond fund managers have had a very difficult time producing satisfactory returns to unitholders. In order to increase returns, managers have been increasing maturities to get higher long term yields or going down the food chain to lower quality bonds, both of which increase the risk profile of the funds.
There are billions of dollars invested in bond funds. Investors in these funds may not realize how much risk they have taken on. When prices do start declining, investors may quickly realize this is not a safe part of their portfolio and begin panic selling. Bond prices are similar to residential real estate in some respects. When your neighbour sells their house at a “fire sale” price, your house is now worth that fire sale price as well.
The abnormalities in today’s bond market are illustrated by a couple of real-world examples of how demand for yield has exceeded a rational assessment of risk. A 15-year, 7.5 per cent Russian Federation bond, trades at a yield of only 3.6 per cent, while an 8.25 per cent Republic of Lebanon, 6-year bond trades at a yield of 5.6 per cent. These compare, for example, to a ten-year IBM bond that trades at a yield of 3.5 per cent. Russia and Lebanon do not represent stable, economically sound debtors, so it is quite surprising their bonds trade at prices providing yields close to those of IBM bonds. And yet the search for yield, anywhere in the world, is in high demand.
In addition to quality risk, liquidity in the bond market has become a major concern for traders. Many sectors, particularly resource companies and small caps, have been unable to raise capital by issuing bonds. This has reduced the available supply of bonds, resulting in higher prices, lower yields and less liquidity, as managers hold their positions longer. Liquidity dries up, bond spreads widen and any selling pressure exacerbates falling prices. We have already seen some smaller bond funds ban redemptions on their funds, most notably Third Avenue in the U.S. Third Avenue Management told investors in one of their mutual funds this past week that they would be blocking redemptions from the fund. While Third Avenue is a distressed debt niche player, rather than a traditional bond fund, the mechanics of the outcome could affect any bond fund that runs into liquidity problems.
IN CONCLUSIONRising interest rates normally result in declining bond prices. This is evident by the negative returns shown this year by bond ETFs. If rising rates persist, returns decline and investors get nervous, redemption requests of bond funds will increase. This may force bond fund managers to sell longer term bonds and lower quality bonds into a declining market, significantly affecting net asset values. If negative sentiment persists and redemption requests mount, bond funds may reach the point where they freeze redemptions in an attempt to orderly wind down the fund.Our portfolio stance is that going into this new rising rate cycle, when bond markets are facing largely unknown and unquantifiable risks, it is not worth the risk of capital to maintain exposure to traditional bonds or bond funds.