To the point Can you time a long duration strategy?

Interest rates are going to rise, so I am going to wait to implement a long duration strategy.
This is one of the most often used reasons for delaying implementation of a long duration strategy. In its simplest form, the implication of this statement is correct: Rising interest rates should make future purchases of longer duration bonds less expensive so why not wait? However, there are three common mistakes that investors can make in waiting for interest rates to increase. The most obvious error investors make is incorrectly predicting if and when interest rates rise. Today, many investors simply assume that rates are low by historical standards, so they must rise. They do not adequately analyze the potential range of outcomes based on the fundamental economic and technical data, nor do they consider the timing of when interest rates might rise. In point of fact, U.S. interest rates have actually fallen since the beginning of 2011. Additionally, interest rates have steadily declined in the recent three-, five- and 10-year periods due to fundamental and technical drivers including a steady decline in inflation, changing risk allocation, weak domestic employment and a weakening housing market. The second one that investors sometimes make concerns risk management. Today, many plans, while adopting a long duration or risk reducing strategy, do not realize the size of the risk position that they have in their financial assets relative to their liabilities. By not having adequate duration in portfolios (or a sufficient overall bond allocation), plans may be giving up downside (economic or interest rate) risk protection and lack significant correlation potential. If interest rates rally further from here, it would probably be accompanied by a weak equity market, which would have the potential to further reduce pensions funded status. Finally, and arguably the most critical one is that investors often do not fully analyze and evaluate the future trajectory of interest rates, pay sufficient attention to forward rate expectations, the future shape of the yield curve or the time horizon over which these changes may occur. These factors are critically important to calculating and comparing total return expectations for core fixed-income strategies versus long duration strategy options for a given time horizon. This is the exercise that this paper will consider and examine. To the point is a publication exclusively for institutional prospects, clients and consultants.

June 2011

To the point

Can you time a long duration strategy? | June 2011

Figure 1: Yield differential between a generic five-year Treasury note and a generic 30-year Treasury bond since March 1992
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Generic 30-year Treasury bond

Generic five-year Treasury note

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Source: Bloomberg

Figure 1 shows the historical yields for generic five-year and 30-year Clearly, the curve steepened in late 2007 as the credit crisis U.S. Treasury securities and how the spread between the two began to unfold. The spread between five-year and 30-year has varied over time. Clearly, after periods of financial stress in Treasuries peaked in November 2010 as the Federal Reserve the markets, the U.S. Treasury yield curve can steepen (yield began the second phase of its quantitative easing program. spreads increase) dramatically, only to be followed by a period However, one might reasonably conclude that as the economy of flattening. As the chart shows, the yield spread between the recovers and returns to a more normal state, the curve should five-year and 30-year maturities steepened dramatically during flatten again. History suggests that the yield curve could flatten the savings & loan (RTC) crisis of the early 1990s. It steepened to between 50 and 100 basis points in yield spread between the again after the terrorist attack on the World Trade Center in 2001 five-year note and the 30-year bond and that this will likely and again during the recent financial crisis beginning in late 2007. happen over a 12- to 24-month period. (As of June 1, 2011, this spread was 252 basis points.) After the first two events, once the curve started to flatten to a more normal level, the bulk of the flattening happened over a To help answer the question of whether one should wait for period of about a year (mid 93 mid 94 and 2004). Ultimately, interest rates to rise to implement a long duration strategy, plan it took less than two years for the curve to reach a minimum sponsors may want to consider forwards or forward Treasury normal level of about 50 basis points spread between the fiverate (yield) expectations to calculate the total return for their year note and the 30-year bond (19942000 and 20052007). current strategy versus all other options. Figure 2: Interest rate forward curves show market expectations for future rates
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Source: Bloomberg 2

To the point
Every day, the market sets a price or expectation for future movements in interest rates for U.S. Treasury notes and bonds. Combining this with current market yields for corporate and mortgage bonds, one can use this as a proxy to estimate changes in the value of a portfolio. For example, forward rates on June 1, 2011 appear in Figure 2. The duration of a six-year Treasury note is approximately equal to that of a Barclays U.S. Aggregate portfolio benchmark at around 5.1 years. Meanwhile, the duration of a 20-year Treasury bond about 12.5 years approximates that of the Barclays Long Government/Credit Index, which is often used as a benchmark for long duration bond strategies. Looking at the chart on the previous page, one can see that, as of June 1, 2011, the market expected U.S. Treasury rates to rise over the next year and rise even further over the next two and three years. Using an interpolated six-year Treasury note to approximate rate movements for Barclays Capital U.S. Aggregate Index, the current prevailing interest rate is 1.97%, the one-year forward rate is 2.64% and the two-year forward rate is 3.31%. This is the market view of where six-year interest rates will be through time, and one can calculate an expected return for a portfolio like the Barclays Aggregate Index (with the assumption that spreads of other fixed-income assets to Treasuries remain unchanged.)1 Over a two-year horizon, one could estimate a portfolio durationmatched to the Barclays Capital U.S. Aggregate Index, with a starting yield of 2.71% to have a capital loss (assuming rates rise as forward curves project) of 6.99% and a negative total return of 0.90%. The table below illustrates this as well. Again, using the 20-year bonds as the proxy for interest rate movements for a portfolio matched to the Barclays Capital Long Government/Credit Index, one can perform the same analysis. Figure 3: Using forward curves to estimate potential returns
Current and forward yield estimates as of June 1, 2011 Interpolated six-year Treasury 20-year Treasury bond Projected returns over a two-year horizon Barclays Capital U.S. Aggregate Index Barclays Capital Long Government/Credit Index Difference in total return
Source: Barclays Capital, Bloomberg, calculation by CGII.
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Can you time a long duration strategy? | June 2011

With a starting yield of 4.81%, one could expect a two year capital loss of 8.31% for a total return of +1.63%. Thus, using the interest rate forward curve for U.S. Treasuries, one could reasonably calculate that, as a result of expectations for higher Treasury yields and a flatter yield curve, a portfolio whose duration is matched to the Long Duration Government/Credit Index would outperform a portfolio benchmarked to the Barclays Capital U.S. Aggregate Index by approximately 2.53% over the next two years. While this may be counterintuitive, it points out that analytical rigor is necessary in guiding investment decisions in fixed income. It is true that interest rate forward curves are not precise and should be used only as a guide. However, it is also true that the U.S. Treasury yield curve is now very steep by historical standards and this cannot last indefinitely. Moreover, the same factors that drive interest rates higher monetary policy, inflation, economic growth expectations also tend to lead to a flatter yield curve. Thus, if an investor has a view biased toward higher rates, it should also lead to an expectation for a flatter yield curve, with short-term rates rising more than long-term rates and quantitatively, it should lead an investor to investing in a long duration strategy versus a strategy benchmarked to the Barclays Capital U.S. Aggregate Index. Conversely, if one thinks that the U.S. recovery will be slower than expected, that interest rates are likely to stay lower for longer and that the yield curve will remain steep, then that pushes off capital losses in both strategies and the higher yielding long government/credit strategy should be the preferred strategy under that set of assumptions as well. Overall, we believe that there is a compelling case to be made for defined benefit plans to consider moving some portion of their fixed-income assets into long duration strategies regardless of their expectations for the level or trajectory of interest rates.

Duration (years)

Current yield %

One-year forward rate %

Two-year forward rate %

5.1 12.5
Starting yield %

1.97 3.84
Accumulated yield %
2

2.64 4.16
Capital loss %

3.31 4.46
Total return %

2.71 4.81

6.09 9.94

6.99 8.31

0.90 1.63 2.53

Some of the other assumptions included are reinvestment of cash flows at original yield, no duration drift, no compounding and no convexity effects. Taking starting yield for the first year and adding yield due to yield-curve steepening for the second year. Securities offered through American Funds Distributors, Inc. Member FINRA. The statements expressed herein are informed opinions, are as of the date published, and are subject to change at any time based on market or other conditions. This publication is intended merely to highlight issues and is not intended to be comprehensive or to provide advice. Permission is given for personal use only. Any reproduction, modification, distribution, transmission or republication of the content, in part or in full, is prohibited.
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