The two main cyclical determinants of fixed-income returns arise from duration risk and credit risk. Duration risk reflects the sensitivity of bond values to fluctuations in interest rates and depends on the distribution of payment through time. The longer the duration of a bond with a fixed payments stream, the more sensitive its price is to interest-rate changes. Credit risk premia refer to the extra interest rate that lower-quality cred- its have to pay above the “risk-free rate” to borrow in the markets. In good times, these premia tend to be much lower than in crises.
Both sources of fluctuations in fixed-income valuations have a pre- dictable cyclical pattern. The monetary policy cycle tends to drive the interest-rate cycle, which in turn determines when in the business cycle it is best to embrace, or to avoid, duration risk. Likewise, there is a cycle in credit risk associated with the stages of the business cycle. There are times when “fear and loathing” dominate credit valuations, and times when complacency rules and investors are willing to take much more risk for very little incremental return. We will address the cyclical behavior in duration and credit risk in turn. First, however, it is helpful to discuss the anchors of longer-term valuation around which these cyclical fluctuations occur.
Valuation anchors
As we saw earlier, in the foreign exchange markets we find that the pri- mary long-term relative-value determinant is the difference between countries’ domestic inflation rates because of purchasing-power-parity forces. Deviations from this basic anchor tend to be self-correcting over very long stretches of time as shorter-term influences get washed out.
For equities, as we will discuss in the next chapter, the valuation anchor tends to be the present value of the earnings capacity of com- panies. However, just as currencies can deviate substantially from their valuation anchors, so too can equities. In fact, secular bull and bear markets tend to be associated with correcting excessive devia- tions from valuation anchors. In 2000, for example, the US equity market was the most overvalued relative to its earnings capacity since at least 1929. It took about a decade of a secular bear market and two business cycles before those valuation excesses were corrected and a new secular bull market began. Essentially, earnings had to grow into the valuations before normal returns could be expected to resume.
For corporate bonds, the fundamental valuation anchor depends on the “normal” structure of the yield curve for Treasuries and the “nor- mal” credit-risk premia that are paid over and above the like-duration Treasury rate, which is used to benchmark credit risk. US Treasury credit is treated as if it has close to zero risk of default because the government borrows in the same currency that it issues and the debt is backed by the full faith and credit of the US government.
The view on inflation is essential for bond valuations and that is why part of the underlying interest-rate outlook embodied in our “new normal” yield curve for Treasury securities includes a view about inflation. Specifically, the “new normal” yield curve that we discussed in chapter 3 is based on a 2-percent inflation rate over the long haul, with a relatively low risk that this inflation anchor will be disrupted by political interference with the Federal Reserve’s long-run goals for monetary policy.
An upward-sloping yield-curve anchor assumes a slightly positive long-term inflation rate. In contrast, a long-run expectation of suf- ficiently high deflation would create a persistently negatively sloped or inverted curve, as in the United States during the post–Civil War era of the late nineteenth century. The main point is that a valuation anchor for the fixed-income market, or any US asset market for that matter, usually requires a view about the macroeconomic growth and monetary policy environment over a longer-term horizon of a decade, or more. A lot of the economic instability in the 1970s arose from the disruption of underlying valuation anchors as inflation accelerated.
The credit-risk premia anchor also seems to have been affected in the mid-1960s as corporate America embraced increasing leverage. Corporate BAA credit spreads over Treasuries fluctuated fairly tightly around 100 basis points between 1945 and 1965. Then, they took a
quantum leap higher that has persisted ever since, with spreads averag- ing about twice that level. This appears to be related to the downshift in profit margins at about the same time. Profit margins are a cush- ion for debt repayment. Higher margins imply more cash available to make debt payments. Lower margins, on the other hand, increase credit risk. Increased leverage and rising interest rates seem to explain much of the shift to lower margins after 1965.
The credit-spread “anchor” also appears to have increased at about the same time with higher interest rates and increased interest-rate volatility, raising the question whether the “new-normal” interest environment we are projecting creates forces that will reduce the credit-spread anchor over time. Such a decline would be consistent with our view that profit margins have broken out to a new higher secular range as a direct result of the declining labor share of income, lower interest rates, and a more efficient allocation of resources in a low-inflation environment. Demographics and increased automation are powerful forces for this secular shift, which will be discussed in our more detailed look at profit margins and equity valuation.
To summarize, valuation anchors are the first step toward establish- ing fundamental asset values, whether for currencies, bonds, or stocks. Some asset values are more easily estimated than others. There are sev- eral ways to value real estate that establish useful anchors (for exam- ple, the capitalization rate simply discounts the net rental streams at a required rate of return to estimate the present value of the property). On the other hand, other assets, such as gold, which doesn’t generate an income stream, seem much less amenable to an anchor valuation based on financial characteristics.
One characteristic of a useful anchor is that it provides a funda- mental force for mean reversion. As a result, anchors are the basis for strategic allocation over longer time horizons. Good models of anchor valuation generally imply the risk and return characteristics that can be expected from an asset class over the long term. To deduce these returns, capital-market assumptions about inflation, interest rates, real economic growth, and regional differences in these parameters are among the model inputs that are generally necessary. Together with correlations across asset classes, these anchor valuations form the basis for strategic portfolio construction.
The conventional approach of asset allocators is to use historical averages for many of the required parameters. Accurately understand- ing structural changes in the fundamental macroeconomics behind the
capital-market assumptions that go into valuation anchors is one of the most valuable insights an investment manager can have. Indeed, most of the crowd operates as if reversion to the historical mean is always the appropriate approach for strategic allocation. However, when funda- mentals change, a new mean can result. Two examples of fundamental changes highlighted in this book are (1) likely lower-than-historical- average future interest rates and (2) higher-than-historical-average profit margins. Both have the effect of raising anchor valuations on equities and lowering the credit-spread “anchor.”
Our focus in this book is on cyclical fluctuations in asset values. These are generally short-term deviations from anchor valuations caused by business cycle pressures on average valuation. This is the basis for a lot of tactical allocation decision-making. Nevertheless, insights about fundamental structural shifts can also add to returns and should be on the radar screen of a good strategist. They can be part of “what’s differ- ent this time” in each business cycle.
Cyclical duration risk and tactical fixed-income allocation Over the course of a business cycle, Treasury bond yields have a high and a low point. Since yields are inversely related to prices, the best time to buy (at the lowest price) comes when the long-term yield makes its cycle high. Conversely, the best time to sell (at the highest price) is when the cyclical low point in long yields is reached. From a tactical viewpoint, this is the simple message from the business cycle: as yields rise from their cycle low point, it is advantageous to be underweight Treasury bonds. As yields peak and begin to fall, it is advantageous to be overweight from the “normal” strategic allocation assigned to fixed income in general, and Treasuries in particular. By doing this, a portfolio achieves a higher return over the cycle than that of a static strategic allocation.
Since longer-duration portfolios lose more when interest rates rise and gain more when interest rates fall, a higher tactical allocation to fixed income and maximum extension of duration within benchmark limitations makes most sense when rates have peaked and are set to decline. This generally occurs when monetary policy is tight and the yield curve is inverted. When long rates are lower than short rates, it’s generally a signal that the tightening cycle is near its end and that prices for Treasuries are set to increase.
Usually, this is when the transition from a “bear-flattening” phase of the cycle to a “bull-flattening” phase takes place. In the “bear-flatten- ing” phase (when the Fed is tightening policy), it is a “bear” market in bonds because bond prices are falling (long-term interest rates are ris- ing). While the whole yield curve shifts up, short rates rise more than long rates (hence the flattening of the curve). This is the early phase of the monetary tightening process when the yield curve is moving from maximum steepness to more-than-normal flatness.
The end phase of the tightening process is signaled by the reluctance of long-term interest rates to move higher even as the Federal Reserve continues to boost short-term interest rates. When the terminal boosts in short-term interest rates are followed by declining long rates, the cycle has moved into the “bull-flattening” phase, when the yield curve can transition from completely flat to inverted. At this point, it usually means that the market is judging incoming economic information as starting to suggest a recessionary slowdown on the horizon and/or waning inflation pressures. Remember that the last tightening phase usually takes place in an environment of excessive wage pressure, low unemployment, tight capacity utilization rates, and rising inflation. These factors tend to keep the Fed tightening until it is convinced that it has turned the tide from rising inflation pressures to declining infla- tion pressures. Anticipation of this tide turn is first seen in longer-term bond yields, in which the incentive to catch the yield peak is greatest from a tactical business cycle timing point of view.
For example, between June 2005 and July 2006, the Federal Reserve raised its funds rate target about 225 basis points from 3.0 percent to 5.25 percent. The ten-year Treasury note yield rose from about 4 per- cent to 5.1 percent over the same period. This was a “bear-flattening” phase with interest rates rising across the maturity spectrum (“bear” phase), but with the overnight rate increase exceeding the ten-year rate increase by about 110 basis points (“flattening”).
During the subsequent year (July 2006-July 2007), the Fed held pol- icy steady at a 5.25-percent funds rate level, while 10-year and 30-year bond yields averaged slightly lower. The curve was slightly inverted for a year as investors guessed that the Fed had finished tightening. This was a good time to overweight Treasuries. Indeed, by December 2007, the recession had begun. The Fed quickly cut the funds rate by a full percentage point during the six months leading up to the recession. A new bond bull market had begun. Those who bought the ten-year
Treasury note around a 5-percent yield in late 2006 and early 2007, when the funds rate was at 5.25 percent, saw big gains by December 2008, when yields plummeted to 2.42 percent.
Timing the cycle is not always easy. As already noted, there are often idiosyncratic risks associated with business cycles. The financial crisis of 2008–2009 again provides a good example. In the summer of 2008, many traditional cyclical indicators were behaving as if the reces- sion would be over by early 2009. The Fed had cut the funds rate to 2 percent by then, from 5.25 percent at the peak, and the ten-year Treasury yield was averaging around 4 percent. The positive 200-basis point yield-curve spread was above normal, suggesting an impending recovery.
All this changed, however, when financial markets began to roil anew in August and September, culminating in the collapse of Lehman Brothers. When Bear Stearns had failed in the spring of 2008, its reso- lution left the impression that creditors would always be protected when the government resolved financial failures. That perception changed when, to their big surprise, creditors lost everything along with equity holders when Lehman failed.
It’s fair to say that these developments were not well anticipated by the bond market. They did, however, dramatically extend the bull market in Treasury bonds. As a result, investors who were overweight Treasuries based on cyclical timing turned out to be doubly blessed by the ensuing financial crisis. Corporate credit, on the other hand, experienced one of the worst bear markets in credit spreads since the Great Depression as the rules of the game were seen to have changed dramatically between the demise of Bear Stearns and that of Lehman. Uncertainty spiraled. Fears of depression and default skyrocketed. Risk appetite plunged. It was the perfect set of circumstances for Treasuries to outperform and a perfect storm for corporate credit to underper- form. The financial crisis exacerbated the “bull steepening” that was already under way well before Lehman Brothers collapsed almost a year into the recession. The fallout from its collapse forced an extraor- dinary fiscal and monetary policy response and delayed the start of the recovery until mid-2009.
With the Fed funds rate pinned near zero and three successive rounds of quantitative easing, the yield curve went through an unu- sual early-cycle phase of “bull flattening” starting in early 2010 as Federal Reserve bond purchases dragged down interest rates across the maturity spectrum. Promises of zero rates for an extended period
added to the downward pressure on longer maturities. This unusual early-cycle “bull-flattening” phase ended in the spring of 2013 when Fed Chairman Ben Bernanke signaled that quantitative easing (QE) needed to be gradually withdrawn. During the year before that, ten- year Treasury yields averaged less than 2 percent, testing the lowest levels since World War II, the last time when the Federal Reserve had engaged in such a massive asset-purchase program.
Bernanke’s signal that asset purchases would be curtailed marked the cyclical turning point for a “bear steepening” to begin. Because this meant lower Treasury prices ahead and bigger price declines for longer-dated Treasuries than shorter-maturity Treasuries, it was the time to underweight fixed income below benchmark strategic alloca- tions and tactically decrease duration. It probably also marked the end of the secular bull market in bonds that began in 1981 during Paul Volcker’s tenure, when the benchmark ten-year Treasury note yielded over 15 percent.
As the market moved from pricing-in the end of the Fed’s long-matu- rity asset purchases in 2014 to pricing in the beginning of Fed rate hikes in 2015, upward pressure on interest rates began to shift from the back of the curve in 2013 to the front in 2014, as shorter maturi- ties are most affected by an anticipated rise in the near-term federal funds rate trajectory. This marked a shift from a “bear-steepening” phase of the cycle to a more normal “bear-flattening” phase, which always occurs when the Fed moves from maximum accommodation toward a more normal monetary policy that moves the yield curve from extremely steep toward its normal (“average”) shape before the actual tightening phase of policy begins to flatten further its normal upward tilt.
While the cycle that culminated in the financial crisis had its idi- osyncratic deviations from the typical business cycle pattern, it also conformed fairly well to the breakdown outlined in Exhibit 4.1, which summarizes the business cycle pattern of duration risk and the optimal tactical fixed-income allocation based on this pattern. In particular, if we treat quantitative easing and extended forward rate guidance as a substitute for further rate cuts when the zero-bound precludes additional interest-rate reductions, then that exceptional monetary policy fits nicely into the framework laid out in the exhibit, with the notable exception that it added a brief period of “bull flat- tening” because of quantitative easing that is unusual for that stage of the cycle.
Exhibit 4.1 shows that more generally, starting with the early-recov- ery phase of the business cycle, there is a period of maximum mon- etary accommodation. This is the phase in which monetary policy is trying to cement the recovery and avoid a relapse into recession. The lowest bond yields of the cycle usually occur early in this phase as additional rate cuts from the Fed are anticipated and doubts about the sustainability of the recovery dominate market sentiment. Since the shape of the yield curve reflects the degree of monetary accommoda- tion over the cycle, the yield curve is usually in its steepest position in this phase of the cycle.
As outlined in our discussion of business cycle patterns, at some point in this phase of the cycle markets start sensing that the Fed’s next move will be a rate hike rather than another rate cut. By that time, the bond yield will have normally bottomed and started to build in the rising interest-rate trajectory for the coming expansion. As that
Exhibit 4.1 Fixed-Income Tactical Response to Duration-Risk Cycle
Business Cycle Phase Fed-Policy Driving Analogy Tactical Duration Position Yield-Curve Move Tactical Deviation From Benchmark Early Recovery Maximum
Monetary Acceleration Start to Reduce Duration to Neutral From Bull to Bear Steepening (QE Bull Flattens the Curve) Overweight to Neutral Early to Mid-cycle Expansion Easing Off
Accelerator Reduce Portfolio Duration to Underweight
Bear
Flattening Neutral to Underweight
Mid-cycle to Late-Stage Expansion
Tapping on
Brakes Increase to Neutral Bear Flattening Underweight to Neutral
Imminent
Recession Brakes On Increase Portfolio Duration to Maximum Inversion and Shift to Bull Steepening Neutral to Overweight
Recession Easing Off Brakes Tapping on Accelerator Stay Overweight Duration Rapid Bull Steepening Overweight
happens, it’s usually a good time to scale back a tactical overweight position in duration to a more neutral weighting.