THE CORE CONUNDRUM - Guggenheim Partners
THE CORE CONUNDRUM - Guggenheim Partners THE CORE CONUNDRUM - Guggenheim Partners
10-Year Treasury Yield these worsening trends in new issuance is currently being obscured by the benign credit environment, a by-product of the Fed’s unprecedented monetary accommodation. As the Fed begins the fifth year of its zero-bound monetary policy, continued expectations for low rates would appear to mitigate the risk of extending duration in pursuit of incremental yield. However, using historical precedent as our guide, the market sometimes fails to effectively discount the potential for sudden monetary policy shifts. Asymmetric Risk in Treasuries During the 1940s, the Fed, acting in concert with the Treasury Department, fixed interest rates on short-term Treasury bills while committing to buy long-term Treasury bonds in order to ensure cheap, adequate financing for World War II and the attendant recovery. The end of this practice, under the Treasury Accord of 1951, led to a tumultuous sell-off in longer-duration bonds as the market failed to anticipate the shift in monetary policy. Once the Fed inevitably begins removing excess Historically, the End of Fed Intervention is Bad News for Bonds U.S. 10-Year Treasury Yields since 1800 15% 13% 1 2 Rate Stability Bear Market in Bonds 11% 9% 7% 5% 3% Treasury Accord 1% 1800 1815 1830 1845 1860 1875 1890 1905 1920 1935 1950 1965 1980 1995 2010 The removal of Fed support of bond prices at the long end of the curve in 1951 set off a bear market in bonds that lasted thirty years. Could history repeat itself once the current period of low rates ends? While we do not think this is imminently possible, future policy change is increasingly a concern. Source: Bloomberg. Data as of 12/31/2012. 8 | COPING WITH NEW MARKET REALITIES GUGGENHEIM PARTNERS
Nominal Total Return Era of “Return-Free Risk” U.S. 10-Year Treasury One-Year Holding Period Returns 15% 10% A 20 basis point move in rates wipes away the total return in 10-year Treasuries 5% 0% -150 -100 -50 0 100 150 200 -5% -10% -15% -20% Change in Interest Rates (Basis Points) U.S. 10-Year Treasury One-Year Holding Period Total Returns Purchasing 10-year Treasuries at current yields comes with considerable duration risk. Today’s low coupon rates mean a 20 basis point rise in rates would lead to a negative total return over a one-year holding period. With the risk in Treasuries heavily skewed to the downside, we believe Treasuries have gone from offering “risk-free returns” to now effectively becoming “return-free risk.” Source: Bloomberg. Data as 12/31/2012. The total return scenario is calculated based on the coupon rate of 1.625% and an effective duration of 9.1. liquidity from the financial system, could a repeat of the 1950s occur? While we do not envision any sudden monetary policy shifts or a meaningful rise in rates in the near term, given where rates are today and how grossly overvalued Treasury securities have become, the risk to rates is clearly to the upside. At current coupon rates, a 20 basis point rise in rates would result in a negative total return on 10-year Treasuries over a one-year holding period. Based on the asymmetrical risk-return profile, we believe Treasuries have gone from offering “risk-free returns” to now effectively becoming “return-free risk.” The dearth of yield within traditional core fixedincome sectors has resulted in an uptick in tracking error as investors increase allocations to riskier investments, such as emerging-market bonds and high-yield debt. According to eVestment Alliance, the average tracking error for core fixed-income strategies rose to 1.09 percent over the past three years ending December 2012, compared to 0.66 percent in the three-year period from 2005 to 2007. Given investors’ increased willingness to venture outside the traditional confines of core fixed-income, in the following section, we propose a more optimal method to generate attractive yields without sacrificing credit quality or extending duration. 9 | COPING WITH NEW MARKET REALITIES GUGGENHEIM PARTNERS
- Page 1 and 2: PORTFOLIO STRATEGY RESEARCH | FEBRU
- Page 3 and 4: SECTION 1 The Core Conundrum In an
- Page 5 and 6: Assessing the Relative Value of the
- Page 7: SECTION 2 Coping with New Market Re
- Page 11 and 12: through overcollateralization, exce
- Page 13 and 14: Barbell means to structure a portfo
- Page 15 and 16: The Changing of the Guard The Futur
10-Year Treasury Yield<br />
these worsening trends in new issuance is currently<br />
being obscured by the benign credit environment,<br />
a by-product of the Fed’s unprecedented monetary<br />
accommodation. As the Fed begins the fifth year of<br />
its zero-bound monetary policy, continued expectations<br />
for low rates would appear to mitigate the<br />
risk of extending duration in pursuit of incremental<br />
yield. However, using historical precedent as our<br />
guide, the market sometimes fails to effectively<br />
discount the potential for sudden monetary<br />
policy shifts.<br />
Asymmetric Risk in Treasuries<br />
During the 1940s, the Fed, acting in concert with<br />
the Treasury Department, fixed interest rates on<br />
short-term Treasury bills while committing to buy<br />
long-term Treasury bonds in order to ensure cheap,<br />
adequate financing for World War II and the<br />
attendant recovery. The end of this practice, under<br />
the Treasury Accord of 1951, led to a tumultuous<br />
sell-off in longer-duration bonds as the market<br />
failed to anticipate the shift in monetary policy.<br />
Once the Fed inevitably begins removing excess<br />
Historically, the End of Fed Intervention is Bad News for Bonds<br />
U.S. 10-Year Treasury Yields since 1800<br />
15%<br />
13%<br />
1 2<br />
Rate<br />
Stability<br />
Bear Market<br />
in Bonds<br />
11%<br />
9%<br />
7%<br />
5%<br />
3%<br />
Treasury Accord<br />
1%<br />
1800 1815 1830 1845 1860 1875 1890 1905 1920 1935 1950 1965 1980 1995 2010<br />
The removal of Fed support of bond prices at the long end of the curve in 1951 set off a bear market<br />
in bonds that lasted thirty years. Could history repeat itself once the current period of low rates ends?<br />
While we do not think this is imminently possible, future policy change is increasingly a concern.<br />
Source: Bloomberg. Data as of 12/31/2012.<br />
8 | COPING WITH NEW MARKET REALITIES GUGGENHEIM PARTNERS
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