From the August 2014 issue of Research Magazine • Subscribe!

Facing the Yield Challenge

Heading into 2014, the consensus view was that U.S. bonds were on the verge of a major bear market and yields on 10-year Treasuries would end the year higher than their 2014 starting point of 3.03%.

Since then, 10-year yields have crumbled 15% toward 2.5%. Put another way, Treasury investors have taken a 15% cut in income. Bond investors invested in debt with maturities longer than 10 years have taken a similar income hit. These are the challenges of today's income-starved bond investors, not to mention hidden credit risk and complacency. It's up to alert advisors to help clients navigate these treacherous waters.

What Credit Risk?

Just three years ago, major credit raters like Moody's and Fitch Ratings held steady on their view the U.S. deserved to keep its pristine credit score. But on Aug. 5, 2011 everything changed. On that fateful day, Standard & Poor's downgraded the U.S. federal government's credit rating from AAA (outstanding) to AA+ (excellent). It was a blow to the U.S. government's reputation and the first time ever it was given a credit rating below AAA.

Instead of skyrocketing bond yields, which many analysts expected, the “penalty” for being downgraded was non-existent. The yield on 10-year U.S. Treasuries has been virtually unchanged at around 2.53% since August 2011, while yields on 30-year U.S. Treasuries has fallen 11.98% to around 3.36%. Deteriorating credit quality did not result in higher borrowing rates!

Furthermore, the U.S. government's debt load has continued to ride higher, mushrooming from $14.9 trillion to $17.6 trillion over the past three years. The top three foreign holders of U.S. debt as of the second quarter were China ($1.26 trillion), Japan ($1.20 trillion) and Belgium ($366.4 billion). Again, despite increasing debt and deteriorating fundamentals, the bond market has shrugged off the risk.

Elsewhere, bond yields in even more fiscally challenged countries like Italy, Spain, and Greece have slid too—to levels that hardly reflect any concern about the possibility of imminent defaults. Italy and Spain pay just 10 to 30 basis points more on 10-year debt compared to similar maturing U.S. Treasuries! Compared to its global peers, the investment grade U.S. bond market has lagged the SPDR Barclays International Treasury Bond ETF (BWX) this year. BWX has climbed 5.66%, or double the return of the total U.S. bond market.

Is the rise of international bond prices and sliding yields a potential warning sign?

“I do feel that lower yields globally are, in fact, a signal that credit risk is being ignored,” said Joseph G. Witthohn, CFA and portfolio manager at Emerald Asset Management in Leola, Pa.

Strategic Opportunities

Despite dwindling bond income, the trend of falling yields and rising bond prices in 2014 has been a trading opportunity extraordinaire for Treasury bulls.

ETFs that benefit from lower yields and higher Treasury bond prices like the ProShares Ultra 20+ Yr. Treasury ETF (UBT) and the Direxion Daily 20+ Yr. Treasury Bull 3x Shares (TMF) have soared between 26% to 39% year-to-date through the end of June. Treasury bonds with long-term maturities (TLT) like those tracked by UBT and TMF are most sensitive to changes in interest rates compared to Treasuries (SHY) with maturities of less than 10-years.

Unleveraged ETFs that invest in long-term debt like the iShares 20+ Year Treasury Bond ETF (TLT) have gained around 12.5% since the beginning of the year, easily outperforming the SPDR S&P 500's (SPY) gain of 7%.

When the dynamic of falling yields changes to a climate of rising yields, the opportunity for strategic bond trades will shift in the favor of bearish ETFs like the ProShares UltraShort 20+ Yr. Treasury ETF (TBT) and the Direxion Daily 20+ Yr. Treasury Bear 3x Shares (TMV). Both funds are designed to increase in value with 2x and 3x daily leverage when Treasury bond prices fall.

Hedging on Rates

“Just like with cigarettes, there should be a warning label attached to high duration bonds and bond funds,” added Witthohn. “If rates rise, which they eventually will, investors might find that these bonds and bond products unexpectedly become hazardous to their financial health.”

Aside from buying inverse performing bond ETFs, another strategy for hedging against future increases in interest rates that has gained popularity recently is a type of bond known as floating rate bonds or “floaters.” Their coupon rate “floats”—meaning the bond's interest payments are variable.

In January 2014, the U.S. Treasury launched its floating rate bonds—a first for the agency. The new floaters have two-year maturities and interest rates are closely tied to the most current 13-week Treasury bill auction. Floaters are an attractive choice for investors looking to capitalize on rising short-term interest rates. However, if short-term rates don't budge, investors are better off sticking with short-term fixed-rate Treasuries.

In 2013, floating rate bond ETFs attracted around $9 billion in assets and were lifted by respectable gains within the bond market of around 0.75% compared to a 13% loss for long-term U.S. Treasury ETFs.

The iShares Floating Rate Bond ETF (FLOT) is the largest floater ETF and has around $3.56 billion in assets. FLOT is composed of U.S. dollar-denominated, investment grade floating rate bonds with remaining maturities between one month and five years. FLOT charges annual expenses of 0.20% and carries a 12-month yield of 0.43%.

Bond Fan Base

One reason the Federal Reserve's deceleration of QE hasn't damaged the bond market is the “strong demand for long-term bonds from institutional investors” that has been supporting the Treasury market, according to Kathy Jones, vice president and fixed income strategist at Schwab Center for Financial Research.

Jones notes that pension funds, insurance companies and foreign central banks usually hold a substantial portion of their assets in long-term Treasuries. Institutional demand for long-term Treasuries has been robust as stocks still trade near all-time highs and investors re-allocate money to bonds.

Retail investors too have preferred bonds over stocks by pouring more money into bond funds. “Much of the money is going into total return funds and/or funds with short to intermediate duration which are less sensitive to interest changes,” said Jones. “The search for yield will continue as long as there are no consequences to investors.”

Caution

Despite the many warnings of higher yields and lower bond prices ahead, investors have been lulled into a false sense of security. They seem to feel that since warnings of higher yields were wrong in the recent past, they are probably wrong for the future.

Although the higher prices have boosted the value of bonds, it's important that advisors remain vigilant about credit risk, the threat of rising interest rates and the danger of reaching for yield.

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