Income Investor Perspectives

Are you using the rearview mirror to figure out where you’re going?

How can an investor measure risk? To non-professionals, duration and standard deviation often don’t really make sense. But yield (or return) is a number that every investor understands, and is often used as the primary point of comparison between different prospective investments.

Return measures, however, are backwards looking. If you are driving, you would not expect good results by looking only in the rearview mirror. How could you prepare for the curve in the road, or the hill up ahead that obscures the view of oncoming traffic? And, what happens if a black swan happens to be crossing the road in front of you?

Historical returns are very important–but they are not the only important data point. Now is a good time to illustrate the importance of understanding what has generated returns in the past, and to have an opinion about where returns will come from in the near future.

With almost everyone calling for a hike in the Fed Funds target rate and therefore a general increase in rates, most bond market participants are counseling investors to avoid taking on maturity risk, typically described using the duration measure. (Modified Duration calculates the amount of expected change in price for a 1 percent instantaneous change in yield, and is a different calculation than Macaulay Duration which is a similar but less often used indicator of interest rate risk.)

Here are some selected figures from the Barclays Fixed Income Indices, as of July 31, 2015:

An investor looking at putting money to work in the bond market right now would be unlikely to select the 20+ year part of the U.S. Treasury market due to the very high interest rate risk–yet that same investor, if looking only in the rear view mirror of trailing returns might be drawn to the attractive 12-month returns of almost 10%. Even with a negative year-to-date return, the maximum duration (and therefore highest interest rate risk) U.S. Treasury 20+ year part of the market could be making a significant positive contribution to the 12-month trailing returns of a portfolio. (The Modified Duration of 18.39 indicates that an immediate change in yield of 1 percent would be expected to result in an over 18% drop in price. Note also that the one-month return looks attractive as well but keep in mind that the bond markets have been distorted by recent drama in Greece, so without the strong July rally, the YTD return would be even lower.) If the bond market continues on its present trajectory, most investors would expect that 20+ year part of the U.S. Treasury market will continue to underperform, dragging down the trailing performance numbers.

This doesn’t mean that investors should ignore the historical returns–but rather they should understand the components of those returns, and consider how those components are likely to perform given the current and expected market conditions.

In addition to historical returns, some of the other factors that bond investors should consider include:

• Current and expected interest rates
• Inflation
• Economic conditions
• Credit trends (perceived by the market, as well as ratings agencies and internal opinions)
• Market supply and demand, liquidity and seasonal variations
• Credit risk
• Foreign currency exchange risk

Keep in mind that when buying and holding individual bonds, the Yield to Maturity (YTM) is a good indicator of what the annualized holding period return will actually be. (YTM does make assumptions about the reinvestment rate earned on the cash flows, so final return could vary somewhat from the YTM calculated at purchase.) Read Benefits of Professional Management for some additional insight on making portfolio decisions.

It is early August, so whether you are heading out on the road for a vacation, or thinking about your bond portfolio “Keep your eyes on the road, your hands upon the wheel.” (cf. Roadhouse Blues, The Doors.)

August 3, 2015. The information contained herein is based on sources believed to be reliable, but its accuracy is not guaranteed. The author does not provide investment, tax, legal or accounting advice. Investors should consult with their own advisor and fully understand their own situation when considering changes to their strategy, tactics or individual investments. Investments in bonds are subject to gains/losses based on the level of interest rates, market conditions and credit quality of the issuer. Additional information available upon request.

©2015 Patrick F. Luby

All Rights Reserved.