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Fixed Income Review – July 2019

We delayed publishing the July Fixed Income Review so we can present fresh data and comment on the surge in volatility following the Fed meeting (7/31) and new tariffs on China (8/1). 

In general, the fixed income markets were mostly sleep-walking through July in anticipation of a July 31st Federal Reserve rate cut and a much-anticipated dovish statement from the Fed.  As if on autopilot, stock markets slogged higher and credit spreads moved tighter throughout the month. Meanwhile, Treasury yields rose modestly after their dramatic declines in May and June. Indeed, as the table below reflects, Treasuries were the only major fixed-income class to lose ground on a total return basis in July. All other categories posted positive returns for the month.

In stark contrast, the ETF table below highlights some of the significant changes we have seen since the beginning of August.

Following the Federal Open Market Committee (FOMC) meeting on July 31 and the subsequent press conference delivered by Chairman Jerome Powell, the future of monetary policy was suddenly in question. For the first time in several months, the Fed failed to deliver a dovish surprise.

Part of Powell’s response to the first question in the press conference regarding the “hurdle” for further rate cuts was as follows:

“…the committee is really thinking of this as a way of adjusting policy to a somewhat more accommodative stance to further the three objectives that I mentioned. To ensure against downside risks, to provide support to the economy that those factors are pushing down on economic growth and then to support inflation. So, we do think it’ll serve all of those goals. But again, we’re thinking of it as essentially in the nature of a midcycle adjustment to policy.”

Despite the evidence and assurances of rate cuts to provide a firebreak against any potential weakening of the economy, Powell’s reference to “a midcycle adjustment” suddenly raised doubts about their conviction for further easing.  

Given the strength of the U.S. economy, the “downside risks” he refers to are clearly emanating from foreign sources. Now add a Fed that may not be ready to cut rates further and the renewed escalation of the trade war between the U.S. and China and one has a potent cocktail for the volatility seen since the end of July.

As can be seen in the tables above, fixed-income markets in July were mostly a non-event but the first several days of August have been full of fireworks. The table below illustrates the move in U.S. Treasury yields since July 31.

Investment grade and high yield markets reacted with some displeasure to Jerome Powell’s comments and new rhetoric from the administration on trade and tariff challenges associated with China. Although the magnitude of the spread changes did not breach any meaningful technical levels, the speed of the change was rather head-snapping.

We end up in a familiar place. If we are to take the Chairman at his word and potential downside risks warrant a rate cut, it becomes even more challenging to justify the valuations investors are being asked to pay to own risky assets. Despite having posted new highs in recent weeks, the S&P 500 has produced a 3.48% annualized total return over the past 18 months along with volatility of 15.5%. High yield bonds have delivered annualized total returns of 4.80% with 12.9% volatility. Net out the most recent inflation data of 1.6% from those numbers and we struggle to understand why investors have been so enthusiastic.

Eighteen months ago, one could buy 10-year Treasuries at a 2.85% yield. The 7-10 year ETF (Ticker: IEF) has delivered 3.55% total return and with only 4.4% volatility. Needless to say, while not glamorous, the risk-free route provided returns on par with stocks and high-yield but with significantly less volatility. Given the risks Chairman Powell has outlined, might Treasuries, despite near-record low yields, be the safe place to hide in fixed income for the time being? Astute, rational investors will either figure that out on their own or the market will impose its will.

All Data Courtesy Barclays

Fixed Income Review – June 2019

As central banks have become collectively more dovish throughout 2019, monetary stimulus appears to be back in control of the economic cycle. The Federal Reserve ratcheted up their easing posture at the June Federal Open Market Committee (FOMC) meeting as one voting member dissented from the group in favor of a rate cut. There were other non-voting members even arguing for a 50 basis point rate cut on concerns about the economic outlook and still muted inflation pressures. Keep in mind this abrupt flip in policy is coming despite unemployment at near half-century lows and inflation hovering around 2.0%, the supposed Fed target.

With that backdrop in play, it is no surprise that June was a good month for all risk assets. Within the Fixed income arena, the riskiest of bonds outperformed against the spectrum of safer fixed-income products. As the table below highlights, every major category performed well with emerging markets (EM) leading the way and investment grade (IG) and high yield (HY) corporate returns close behind.

Fixed income has now completed a “round trip” from June 2018 as yields and spreads in almost every category are back below the levels observed at the same time last year. The tables below illustrate those moves in both yields and spreads.

The anticipation of what is being called “insurance rate cuts” from the Fed as well as easing measures expected from the European Central Bank (ECB), offered investors comfort that these potential actions will keep downside risk and volatility at bay. The hope is that the central bankers are sufficiently ahead of the curve in combating weaker global growth.

Despite investor optimism about the outlook as evidenced in the first half performance, risks remain. Most notably, ongoing deceleration in trade and industrial activity could worsen and bring an end to the current record-long economic U.S. expansion. The United States is surrounded by economies that are faltering, including Canada, Australia, Europe, Japan, much of southeast Asia and, most importantly, China. The Trump trade policy agenda only adds to these risks, especially for those countries dependent on exports for economic growth.

If risks do not abate, then we should expect forceful actions from central bankers. The common response of Treasury yields and the yield curve is for the short end (out to two- or three-year maturities) to drop significantly and the long end to either hold steady or fall but much less so than short rates resulting in what is called a bullish curve steepener. As we discussed in Yesterday’s Perfect Recession Warning May Be Failing You, past episodes of rate cuts illustrate this effect.

With investors complacent, yields and spreads on risky assets back to extremely rich levels, and global trouble brewing, the pleasant by-product of recent Fed rhetoric might quickly be disrupted. If so, the gains of the first half of 2019 would become a vague memory.

Apart from slowing global trade and industrial activity, keep in mind there are plenty of other potentially disruptive issues at hand including China leverage, Brexit, the contentious circumstances between the U.S. and Iran, the Italian government fighting with the European Commission on fiscal issues, Turkish currency depreciation, on-going problems in Argentina and more.

At the moment, the Fed and the ECB appear to have the upper hand on the markets, and higher yielding asset alternatives that reward an investor for taking risk are benefiting. Still, a critical assessment of the current landscape demands that investors engage and think critically about the risk-reward trade-off under current circumstances. The Fed and the ECB are not hyper-cautious and dovish for no reason at all. There is more to the current economic dynamic than meets the passive observer’s eye.

All Data Courtesy Barclays

Fixed Income Review – May 2019

To quote from last month’s FI Review, “The performance for the rest of the year no doubt depends more on coupon than price appreciation as spreads are tight and headwinds are becoming more obvious…

On the surface, it looks as though fixed income had another excellent month with the exception of the high yield (junk) sector. Year-to-date, total return gains range from between 3.5% (MBS, ABS, CMBS) to 7.3% (junk). With equity markets up 9-10% through May, bonds are, to use horse racing vernacular, holding pace and stalking. But the monthly total return data does not tell the whole story as we shall see.

To start with an important backdrop for all asset classes, the decline in yields during May was eye-catching and most notable was the sharp inversion of the 3-month to 10-year curve spread. The table below highlights yield changes for May and the curve inversion.

The graph below shows the yields on the 3-month T-bill and the 10-year Treasury note as well as the yield spread between the two. Past inversions of this curve have tended to signal the eventuality of a recession, so this is a meaningful gauge to watch.

To reference the lead quote above, we maintain that spread tightening has most likely run its full course for this cycle and performance will largely be driven by carry. That said, we offer caution as the risk of spread widening across all credit sectors is high, and May might be offering clues about what may yet come.

The first four months of the year highlighted excellent risk-on opportunities. However, with Treasury yields now falling dramatically, they seem to signal bigger problems for the global and domestic economy than had previously been considered. The Treasury sector handily outperformed all others in May and higher risk categories (Junk and EM) were the worst performers. This is a reversal from what we have seen thus far in 2019.

Summer winds are blowing in trouble from the obvious U.S.-China trade dispute but also from Italy, Brexit, Iran, and Deutsche Bank woes.

To highlight the relationship between the historical and recent month-over-month moves in the S&P 500 returns and those of investment grade and high yield bonds, the scatter chart below offers some compelling insight. The green marker on each graph is the month of April, and the red marker is May.

Investment grade bonds have less sensitivity to equity market moves (trendline slope 0.124) and, as we should expect, high yield bonds have return characteristics that closer mimics that of the stock market (trendline slope 0.474). The scales on the two graphs are identical to further stress the differences in return sensitivity.

Finally, when looking at the spread between 5-year Treasuries and investment-grade bonds (similar duration securities) versus the spread between 5-year Treasuries and high-yield bonds, the spread widening since the end of April has been telling.

The investment grade spread to Treasuries widened by .019% (19 bps) and .82% (82 bps) against junk. Netting the risk-free interest rate move in Treasuries for May reveals that the pure excess return for the investment grade sector was -1.39% and for high yield it was -2.49%.

The month of May offered a lot of new information for investors. Most of it is highly cautionary.

All Data Courtesy Bloomberg and Barclays

Fixed Income Review – April 2019

The positive trends of the first quarter extended into April with broad-based total return gains across nearly every major fixed-income category. Only the safest corners of the bond markets posted negative returns last month, albeit those losses were quite minor in contrast with the positive returns since the end of 2018.

Returns in April, across the spectrum of indices, were not as impressive as those seen in the first three months of the year. No one expected those types of moves nor would anyone, having enjoyed them, expect them indefinitely. The performance for the rest of the year no doubt depends more on coupon than price appreciation as spreads are tight and headwinds, especially in credit-sensitive sectors, are becoming more obvious as we will discuss below.

As mentioned, the only two modest losers in April were Treasuries and securitized products (mortgages, asset-backeds, and commercial mortgages). Otherwise, the high yield sector again won the day head and shoulders above investment grade corporates, the next closest performer. According to the heat map below, like last month, all sectors are green across all longer time frames adding emphasis to the impressive rally seen since Christmas.

We would not speculate on the likelihood of this trend continuing, as odds favor a weaker performance trajectory. That does not mean poor performance, but risks rise with prices and spreads perched at historically tight levels.

The charts below illustrate the option-adjusted spreads (OAS) for the major categories in the corporate universe. They have all tightened dramatically since the end of the year. If we are correct that the spread tightening is largely done, then the preference would be to play for safety, and some interest carry for the next few months. In doing so, one may miss another unexpected move tighter in very risky high yield bond spreads; however, given current spread levels, one may also avoid increased odds of poor performance and possible losses.

Understanding that compounding wealth depends on avoiding large, damaging, emotional losses we would prefer to accept the risk of lower returns with high-grade securities while reducing our exposure to the riskier, more volatile sectors.

Although cheapening more dramatically than the Investment Grade (IG) sector in the fourth quarter, High Yield (junk) bonds recaptured much of that in the first four months of this year and in doing so returns junk bonds to (more than) full-value status.

The same can also be said for the lower credit sectors within the IG population. A long-term perspective offers proper context for where valuations are today relative to the past 25 years. The risk is clearly skewed to wider credit spreads and cheaper valuations (losses).

The Trend Continues

The recent tightening of spreads offers little new to discuss other than some deceleration of price and spread action. Importantly, and as recent articles have emphasized, this is a very late stage cycle rally. Risks are rising that corporate margin headwinds, slowing global economic activity, and a high bar for rate cuts given the optical strength of the economy limit the scope for price and spread gains in credit.

Overweighting lower rated credit sectors of the fixed income market is currently akin to the well-known phrase “picking nickels up in front of a steam roller.”

All Data Courtesy Barclays

Fixed Income Review – March 2019

The first quarter of 2019 offered one of the most powerful surges in risky asset valuations seen in history. Closing at 2506 on December 31, 2018, the S&P 500 proceeded to rise 328 points (14.37%) to 2834 in the first quarter. The near vertical leap skyward corresponds directly to the abrupt change in posture from the Federal Reserve (Fed) as they eliminated all threats of rate hikes in 2019. They took the further step of announcing a schedule to halt quantitative tightening (QT).

As might be expected, high yield credit was the best performing sector for the quarter with a total return of 7.26%. Somewhat counter-intuitively, U.S. Treasuries (+2.11%) also rallied for the quarter although they lagged all other major fixed-income sectors as shown in the table below.

For March, risk markets stalled slightly after the big run in the prior two months. Although posting returns of nearly 1%, high yield was the worst performer while investment grade was the best.

The contrast in performance between high-quality and low-quality bonds may be telling. In what could be a related issue, interest rate volatility in the U.S. Treasury market as measured by the MOVE Index spiked higher mid-month and had implications for the credit markets.

As shown in the tables below, only the BBB spread tightened slightly with all others widening by 1-3 basis points. Putting it together, despite solid total returns for the month, the spread widening tells us that corporate credit did not keep pace with falling Treasury yields in March, particularly at the end of the month.

From a macro perspective, the changes in Treasury yields and the yield curve raise broad concerns. Namely, are we nearing the end of the current expansion? As discussed in far more detail in our prior article, Yesterday’s Perfect Recession Warning May Be Failing You, the yield curve has a durable track record of signaling major changes in the economic cycle especially when it inverts (longer-term interest rates drop below short-term rates). When an inverted curve is considered with the end of a Fed rate hike cycle, the evidence becomes even more compelling. The Fed abruptly altered their outlook for monetary policy in March putting to rest any concern for further hikes. The market is now pricing for 1 or 2 rate cuts in 2019.

The last time we observed this combination of circumstances, an inverted curve and a market implying fed funds rate cuts, was ominously in late 2006. In October of last year, when the yield curve spread was decidedly positive, most economists including National Economic Council director Larry Kudlow pointed to this barometer and said we were nowhere near recession. The current market narrative now claims we should not pay too much attention to this important historical precedent. As opposed to trying to shape the narrative to suit our interests, we prefer instead to heed history. The odds are that this time is not different.

Time will tell.

All data sourced from Bloomberg and Barclays

A Traders’ Secret For Buying Munis

Believe it or not, any domestic bond trader under the age of 55 has never traded in a bond bear market. Unlike the stock market, which tends to cycle between bull and bear markets every five to ten years, bond markets can go decades trending in one direction. These long periods of predictable rate movements may seem easy to trade, especially in hindsight, but when the trend changes, muscle memory can trump logic leaving many traders and investors offside.

If you believe higher yields are upon us in the near future, there are many ways to protect your bond portfolio. In this article, we present one idea applicable to municipal bonds. The added benefit of this idea is it does not detract from performance if rates remain stubbornly low or fall even lower.  Who says there is no such thing as a free lunch?

Munis

Municipal bonds, aka Munis, are debt obligations issued by state and local government entities. Investors who seek capital preservation and a dependable income stream are the primary holders of munis. In bear markets, munis can offer additional yield over Treasury bonds, still maintain a high credit quality, and avoid the greater volatility present in the corporate bond or equity markets.

Munis are unique in a number of ways but most notably because of their tax status. Please note, munis come in taxable and tax-exempt formats but any reference to munis in this article refers to tax-exempt bonds.

Because of their tax status, evaluating munis involves an extra step to make them comparable to other fixed income assets which are not tax-exempt. When comparing a muni to a Treasury, corporate, mortgage backed security, or any asset for that matter, muni investors must adjust the yield to a taxable equivalent yield. As a simple example, if you are in a 40% tax bracket and evaluating a muni bond yielding 2%, the taxable equivalent yield would be 3.33% (2.00% / (1-40%). It is this yield that should be used to equate it to other fixed income securities.

Negative “Tax” Convexity Matters

Thus far, everything we have mentioned is relatively straight-forward. Less well-understood is the effect of the tax rate on muni bonds with different prices and coupons. Before diving into tax rates, let’s first consider duration. Duration is a measure that provides the price change that would occur for a given change in yield. For instance, a bond with a duration of 3.0 should move approximately 3% in price for every 1% change in yield.

While a very useful measure to help quantify risk and compare bonds with different characteristics, duration changes as yields change. Convexity measures the non-linear change in price for changes in yield. Convexity helps us estimate duration for a given change in yield.

For most fixed rate bonds without options attached, convexity is a minor concern. Convexity in the traditional sense is a complex topic and not of primary importance for this article. If you would like to learn more about traditional convexity, please contact us.

Munis, like most bonds, have a small amount of negative convexity. However, because of their tax status, some muni bonds have, what we call, an additional layer of negative tax convexity. To understand this concept, we must first consider the complete tax implications of owning munis.

The holder of the muni bond receives a stream of coupons and ultimately his or her invested principal back at par ($100). The coupons are tax free, however, if the bond is sold prior to maturity, a taxable capital gain may occur.

The table below illustrates three hypothetical muni bonds identical in structure and credit quality. We use a term of 1 year to make the math as simple as possible.

In the three sample bonds, note how prices vary based on the range of coupons. Bond A has the lowest coupon but compensates investors with $2.41 ($100-$97.59) of price appreciation at maturity (the bond pays $100 at maturity but is currently priced at $97.59). Conversely, Bond C has a higher coupon, but docks the holder $2.41 in principal at maturity.

For an uninformed investor, choosing between the three bonds is not as easy as it may appear. Because of the discounted price on bond A, the expected price appreciation ($2.41) of Bond A is taxable and subject to the holder’s ordinary income tax rate. The appropriate tax rate is based on a De minimis threshold test discussed in the addendum. Top earners in this tax bracket pay approximately 40%.

Given the tax implication, we recalculate the yield to maturity for Bond A and arrive at a net yield-to-maturity after taxes of 4% (2.50% + (2.50 *(1-.40). Obviously, 4% is well below the 5% yield to maturity offered by bonds B and C, which do not require a tax that Bond A does as they are priced at or above par. Working backwards, an investor choosing between the three bonds should require a price of 95.88 which leaves bond A with an after tax yield to maturity of 5% and on equal footing with bonds B and C.

Implications in a rising yield environment and the role of “tax” convexity

Assume you bought Bond B at par and yields surged 2.50% higher the next day. Using the bond’s stated duration of .988, one would expect Bond B’s price to decline approximately $2.47 (.988 * 2.5%) to $97.53. Based on the prior section, however, we know that is not correct due to the tax implications associated with purchasing a muni at a price below par. Since you purchased the bonds at par, the tax implication doesn’t apply to you, but it will if anyone buys the bond from you after the 2.5% rise in yields. Therefore, the price of a muni bond in the secondary market will be affected not just by the change in rates, but also the associated tax implications. Assuming the ordinary income tax rate, the price of Bond B should fall an additional $1.65 to $95.88.  This $1.65 of additional decline in Bond B’s price is the penalty we call negative tax convexity.

The graph below shows how +/- 2.50% shifts in interest rates affect the prices of bonds A, B, and C. The table below the graph quantifies the change in prices per the shocks. For simplicity’s sake, we assume a constant bond duration in this example.

It is negative tax convexity that should cause investors, all else being equal, to prefer bonds trading at a premium (such as bond C) over those trading at par or a discount. It is also worth noting that the tax convexity plays an additional role in the secondary market for munis. Bonds with prices at or near par will be in less demand than bonds trading well above par if traders anticipate a near term rise in yields that will shift the par bond to a discounted price.

Summary

Yields have fallen for the better part of the last thirty years, so muni investors have not had to deal with discounted bonds and their tax implications often. Because of this, many muni investors are likely unaware of negative tax convexity risk. As we highlighted in the table, the gains in price when yields fall are relatively equal for the three bonds but the negative deviation in price in a rising yield environment is meaningful. Given this negative divergence, we recommend that you favor higher coupon/ higher priced munis. If you currently own lower priced munis, it may be worth swapping them for higher priced (higher coupon) bonds.


Addendum: De minimis

The tax code contains a provision for munis called the de minimis rule. This rule establishes the proper tax rate to apply to capital appreciation. The following clip from Charles Schwab’s Bond Insights provides a good understanding of the rule.

The de minimis rule

The de minimis rule says that for bonds purchased at a discount of less than 0.25% for each full year from the time of purchase to maturity, gains resulting from the discount are taxed as capital gains rather than ordinary income. Larger discounts are taxed at the higher income tax rate.

Imagine you wanted to buy a discount muni that matured in five years at $10,000. The de minimis threshold would be $125 (10,000 x 0.25% x five years), putting the dividing line between the tax rates at $9,875 (the par value of $10,000, minus the de minimis threshold of $125).

For example, if you paid $9,900 for that bond, your $100 price gain would be taxed as a capital gain (at the top federal rate of 23.8%, that would be $23.80). If you received a bigger discount and paid $9,500, your $500 price gain would be taxed as ordinary income (at the top federal rate of 39.6%, that would be $198).

It is important to note that some bonds are issued at prices below par. Such bonds, called original issue discount (OID), use the original offering price and not par as the basis to determine capital gains. If you buy a bond with an OID of $98 at a price of $97.50, you will only be subject to $0.50 (the difference between the OID price and the market price) of capital gains or ordinary income tax.

Higher Rates Are Crushing Investors

There is an old saying that proclaims, “it’s not the size of the ship, but the motion of the ocean.” Since this is a family-friendly publication, we will leave it at that. However, the saying has a connotation that is pertinent to the bond market today. Much of the media’s focus on the recent surge in yields has been on the absolute increase in numerical terms. The increase in rates and yields, while important, fails to consider the bigger forces that can inflict pain on bond holders, or sink the ship. When losses accumulate and fear of further losses mount, volatility and other instabilities can arise in the bond market and bleed to other markets, as we are now beginning to see in the equity markets.

Since 1983, fixed-income investors have been able to put their portfolios on autopilot, clip coupons and watch prices rise and yields steadily fall. Despite a few bumps on this long path, which we will detail, yields, have declined gradually from the mid-teens to the low single digits.

In this piece, we discuss the effect that higher yields are having on debt investors today and compare it to prior temporary increases in yield. It is from the view of debt investors that we can better appreciate that the “motion” is much bigger today than years past.

The Motion of the Bond Ocean

As we alluded in the opening, the losses felt by bond investors cannot be calculated based solely on the amount that yields rise. For instance, if someone told you that yields suddenly rose by 1%, you have no way of estimating the dollar losses that entails for any investor or the entire universe of bond holders. For example, an investor holding a 1-month Treasury bill will have a temporary and inconsequential loss of less than 0.10%, but it will be erased when the bill matures next month. Conversely, a holder of a 30-year bond will see the bond’s value drop by approximately 20%. This example demonstrates why a bond’s duration is so important. In addition to duration, it is critical to know the cumulative amount of bonds outstanding to understand the effects of changes in yields or interest rates.

Comparing yield changes to prior periods without respect for duration and amount of debt outstanding is a critical mistake and has led to an under-appreciation of the losses already incurred by the recent rise in rates and the potential future losses if rates increase further. The importance of this analysis comes back to the central premise of an investor’s objective – wealth is most effectively compounded by avoiding large losses. In the end, we care less about the change in interest rates than we do the impact of that change on the value of a portfolio.

Amount of Debt Outstanding: Since 1993 total U.S. debt outstanding, including federal government, municipalities, consumers, and corporations have risen from about $14 trillion to nearly $60 trillion, a 318% increase as graphed below. The table below the graph compares the surge in outstanding debt among the various issuers of debt as well as the nation’s GDP.

Data Courtesy: Bloomberg

Duration of Debt Outstanding: The duration of a bond is a measure of the expected change of a bond’s price for a given change in yield. For example, the U.S. Treasury 10-year note currently has a duration of 8.50, meaning a 1% change in its yield should result in an approximate 8.50% decline in price. Since it quantifies the price change of a bond for a given change in interest rates, it affords a pure measure of risk. For simplicity’s sake, we omit a discussion of convexity, which measures the second order effect of how duration changes as yields change.

Think of duration as a fulcrum as shown below.

As illustrated, an investor of these cash flows would receive the weighted average of the present value of all of the expected cash flows at the three year mark.

Duration is a function of the current level of yields, the nominal coupon of the security, and the time to maturity of the debt issued.

The following graph highlights that the weighted average duration of total U.S. debt outstanding (including Federal, consumer, municipal and corporate) has increased by approximately 1.30 years to almost 6 years since 1993. All else equal, a 1% increase in yields today would result in an approximate 6.0% loss across all U.S. debt versus a 4.7% loss in the early 1990’s.

Data Courtesy: Bloomberg

The table above shows the changes in duration for various classes of fixed-income instruments since 1993. Consumer debt includes mortgages, credit cards and student loans. As an aside, the increase in yields since 2016 has caused the duration of mortgage-backed securities (MBS) to increase by over 3.0 years from 2.25 to 5.30 years.

Duration and Amount of Debt Outstanding

If we combine the duration and debt outstanding charts, we gain a better appreciation for how fixed-income risk borne by investors has steadily increased since 1993. The following graph uses the data above to illustrate the sensitivity of bond investors’ wealth to a 1% change in yields. For this analysis, we use the change in 5-year U.S. Treasury yields as it closely approximates the aggregate duration of the bond universe.

Data Courtesy: Bloomberg

The table below displays the way that the recent uptick in bond yields has been commonly portrayed over the prior few months.

Tables like the one above have been used to imply that the 2.13% increase in the 5-year U.S. Treasury yield since 2016 is relatively insignificant as three times since 1993 the trough to peak yield change has been larger. However, what we fear many investors are missing, is that the change in rates must be contemplated in conjunction with the amount of debt outstanding and the duration (risk) of that debt.

The table below combines these components (yield change, duration, and debt outstanding) to arrive at a proxy for cumulative dollar losses. Note that while yields have risen by only about two-thirds of what was experienced in 1993-1994, the dollar loss associated with the change in yield is currently about three times larger. Said another way, yields would have needed to increase by 9.73% in 1993-1994 to create losses similar to today.

Data Courtesy: Bloomberg

Summary

We have often said that our current economic environment is much more sensitive to changes in interest rates because of the growth in debt outstanding since the financial crisis and the recent emergence from the ultra-low interest rate period that crisis produced. Although 5-year yields have only risen by 2.13% from the 2016 lows, losses, as shown above, are accumulating at a faster pace than in years past.

Furthermore, because of the difference between the amount of debt outstanding and the actual currency in the economic system, most of that debt represents leverage. It is beyond the scope of this article to explore those implications but, as illustrated in the table above, rising rates will decidedly reveal the instabilities we fear are embedded in our economy but have yet to fully emerge.

If we are near the peak in interest rates for this cycle, then unrealized losses are likely manageable despite the anxiety they have induced. On the other hand, if we are in the process of a secular change in the direction of rates and they do continue higher, then nearly every fixed-income investor, household, corporation and the government will be adversely impacted.