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The cost of waiting for interest rates to rise

The unforeseen pitfalls of “staying short” with your client’s fixed income allocation

Friday, September 10, 2010 – 4:13 AM by By Stephen J. Huxley, PhD and Brent Burns
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Brent Burns, Stephen Huxley: Since 1927, the probability of rates rising sufficiently fast enough for the [wait-in-cash] decision to be break-even is 11.1%.

Brooke’s Note: A bond trader friend of mine is fond of saying: Buy bonds, wear diamonds. This may be true but it presumes that you buy them intelligently [so you’ll still be wearing a shirt]. Surprisingly little is written on bond investments relative to the position that this asset class holds in people’s portfolios. The author’s of this article, Stephen Huxley and Brent Burns, offer insight on the topic and will also elaborate on the topic in an upcoming webinar. To register, you can click here.

In these interesting times in the markets, low interest rates have led to a paralysis of sorts for many investors and their investment advisors, especially when it comes to investing in fixed income. There have recently been unprecedented flows into bond funds in the past 18 months.

This includes $185 billion flowing into bond funds through the first 7 months of 2010 on the heels of $357 billion being poured into bond funds in 2009, according to Morningstar. Compare this to the last time period — 2001 to 2003 as the tech bubble burst — when investors were fleeing equities in favor of fixed income. Bonds funds received inflows of $65 billion, $129 billion and $45 billion in 2001, 2002 and 2003. See this viewpoint from a bond fund manager: Advisor: Muni’s no longer seem the deal they once did, but some deserve a look

Yet these record inflows are occurring at a time when prominent bond fund managers are actively warning investors that this might not be the right time to do so, as those investments might lead to unforeseen outcomes.

Rates have generally been falling for the last 30 years since they peaked in 1981, and are now at what many consider to be historic lows. See: As a result, the general feeling among market experts, industry analysts and the financial advisory community is a looming switch to a rising interest rate environment, posing the challenge for investment advisors of identifying when rates will rise and by how much. Absent a reliable market timing strategy, advisors must weigh the costs of waiting for rates to rise rather than acting now.

Resolving the dilemma

To solve this dilemma, we have evaluated a number of scenarios and decisions to determine the best probabilities for success in constructing fixed income portfolios, beginning first with which investment products are the most optimal and then whether to act now or wait for rates to rise.
Individual bonds or bond funds?

In a falling interest rate environment, individual bonds and bond funds behave similarly, both providing the ability to deliver total return above the average coupon of the portfolio. When rates rise, however, individual bonds and bond funds do not behave the same. Bond funds often have flat or even negative returns because rising rates cause prices to fall, generating total return below the average coupon of the portfolio.

Individual bonds, on the other hand, have a return floor when they are held to maturity, protecting the downside by “immunizing” from interest rate risk. Immunization definition – when a bond portfolio is immunized, the investor receives a specific rate of return over a given time period regardless of what happens to interest rates during that time.

Thus, for a rising interest rate environment, using an immunized portfolio of individual bonds is the preferred solution over a traditional bond fund, especially when an investor is likely to utilize that bond investment to provide income in retirement.

Invest now or wait?

For this decision, there are four scenarios to consider:

  • Buy a fully immunized portfolio of individual bonds that match the client’s expected cash flow needs now
  • Invest your clients in cash and wait for rates to rise
  • Invest your clients in shorter duration bond funds and wait for rates to rise (what seems to be the most popular choice today)
  • Invest your clients in longer duration bond funds (like advisors have much of the past 30 years) and use total return to generate cash flows

To best illustrate which of these choices makes the most sense, it is helpful to use an example. In this case, assume your client is retiring in 2 years and is looking to replace their paycheck with income from their portfolio of $100,000 per year plus 3% inflation. The cost to buy 8 years of immunized income in the form of individual bonds for this client today is roughly $733,000.

If we stay in this current low rate environment for the next two years, the cost to buy that same 8 years of immunized income if rates don’t change would be about $787,000. The portfolio would cost more because the client would be buying on the shorter end of the yield curve, trading the 9 and 10 year bonds for the 1 and 2 year bonds.

The majority of the time, the cost of market timing interest rates does not benefit the client because an immunized portfolio locks in the base rate even in the rising rate environment. In the example above, the cost of waiting is about $54,000 or 7% of the client’s entire fixed income portfolio.

For “Wait in Cash” to pay off, interest rates would need to rise such that the cost in 2 years plus the marginally higher rates on cash will put the client in the same place as if he/she had purchased now. Since 1927, the probability of rates rising sufficiently fast enough for the decision to be break-even is 11.1%.

Rule-of-thumb

The “Wait in Shorter Duration” decision is a bit of a moving target. Duration Definition: A measure of the sensitivity of the price (the value of principal) of a fixed-income investment to a change in interest rates. Duration Rule-of-Thumb: A 1% rise in the yield curve will lead to a corresponding percentage price drop roughly equal to a portfolio’s duration. For example, a 1% rate rise leads to an approximate 5% price drop for a portfolio with a 5 year duration. The Wait in Shorter Duration strategy is even less likely to be successful than Wait in Cash.

Extending duration in a bond fund beyond cash will lead to low or negative returns as rates rise. The duration mismatch between the client’s cash flows and the portfolio create a very unlikely opportunity. Rising rates would have to exceed the cash model because of the decline in the bond portfolio value. The further the duration extends, the worse the problem will get. In most scenarios, it is mathematically impossible to catch up using bond funds of any duration greater than cash.

In the case of choosing a total return strategy with bond funds, the total return net asset value (NAV) is directly related to interest rates, which falls as rates rise. The income return is the weighted average of the portfolio’s coupons and is always positive. When interest rates rise, Total Return is always below the weighted average of the coupon if the portfolio is not immunized. An analysis of the most recent sustained period of rising interest rates from 1950 to the peak in 1981, showed that the Total Return approach ran out of money 59% of the time when compared to immunized approaches that by definition generated the exact cash flows needed every time.

This analysis points to the benefits of building income matching or immunized bond portfolios in this current low interest rate environment to remove the guesswork of what to do now, regardless of which way interest rates go.

Buying and holding bonds to maturity removes the NAV risk in bond funds and lowers the risk of going further out the yield curve since the return of principal from each bond is meant to be spent in the year it comes due.

Combined with sophisticated mathematical programming, immunizing portfolios allows for a reduction in the amount of the clients’ capital that is required to “purchase” the cash flow, saving the client thousands of dollars over the life of the portfolio.

Conclusions

  • Individual bond strategies in this interest rate environment are best positioned to benefit investors over bond funds
  • Waiting to implement an individual bond strategy will cost your clients money because the mathematics are stacked against the chance that the portfolio will be able to catch up to the 250-300 bps that are given up each year of waiting
  • Shortening the duration of clients’ fixed income exposure is even less likely to work (than staying in cash), even if rates start to rise immediately.
  • When rates eventually rise, Total Return using bond funds will not be a successful strategy.
  • An income matching immunized bond portfolio can bring an even greater benefit to fixed income investors in this interest rate environment.

Stephen J. Huxley is Chief Investment Strategist and Founding Partner of Asset Dedication, LLC. A recognized expert in finance, investing and economics, Stephen has more than 35 years of experience researching and applying decision theory to real world problems.
Brent Burns is President and Founding Partner of Asset Dedication, LLC. Brent’s deep background in empirical finance formed the basis for Asset Dedication’s modeling and analysis. His work with Asset Dedication began more than a decade ago at the University of San Francisco, where he partnered with co-Founder Steve Huxley as to study portfolio performance and the impact of withdrawal rates, inflation, and market conditions.
To learn more about the assumptions and details of this article, we invite you to join the authors for a special webcast hosted by Asset Dedication, LLC September 14, 2010 at 4pm ET. To register, please click here.



Mike Flaherty

Mike Flaherty

November 15, 2010 — 7:59 PM

Great article. Can you walk me through the math/assumptions in your example? Thank you in advance for your assistance.

Stephen J. Huxley

Stephen J. Huxley

November 15, 2010 — 9:11 PM

The analysis was based on the yield curve going back to 1927. We computed how much rates would have to rise to make the cost of the 1-8 year portfolio drop from $787,000 to the cost of the 3-10 year prortfolio, $733,000, assuming the slope of the yield curve remains the same. We then looked to see how often rated had risen that far that fast. The answer was about 11% of the time.

Jeroen

Jeroen

December 24, 2014 — 8:49 PM

Hi,

Thanks for this piece. I have been trying what to decide what to do about this issue myself. What about putting your bond portion of your portfolio allocation into TIPS for the time being?

Would love to hear your opinion.

Regards,
Jeroen

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