Tag Archives: interest rate risk

The Results are in for my January CNBC Experiment: It Proves Nothing and Everything. What?

07 Friday Feb 2014

Posted by in asset allocation, beta, bonds, business, Consumer Finance, currency, Education, EM, emerging markets, Fed, Fed Taper, Fed Tapering, Federal Reserve, finance, financial planning, foreign currency, forex, fx, Individual Investing, interest rates, investing, investments, math, NailedIt, personal finance, portfolio, rising interest rate environment, rising interest rates, risk, statistics, stock prices, stocks, Suitability, volatility, Yellen

≈ 1 Comment

Tags

, , , , , , , , , , , , , , , , , , ,

Sometimes the most important lessons in the individual investing sphere are complicated and simple at the same time.  At the very beginning of January, I recommended a little experiment that related to the financial market coverage on CNBC.  The specific details of this “thought experiment” can be found in the original blog post from January 1st:

https://latticeworkwealth.com/2014/01/14/happy-new-year-beginning-thoughts-and-information-for-international-viewers-2/

The brief version of the exercise related to watching Monday and Friday coverage of the current events in the global financial markets during the month.  The simple exercise was to watch CNBC’s Squwak Box every Monday during the course of the month.  The second part was to watch the last hour of the Closing Bell segment.  What was the logic?  The Monday show is a three-hour program, and there are many current issues considered and opinions from various market participants (e.g. traders, money managers, economists, investment strategists, research analysts, etc.).  Monday is critical due to the fact that the market participants cannot trade on Saturday and Sunday.  You might think of it as “forced” time to think and/or reflect about how current events are affecting investment opportunities and risks.  Friday’s reflections from the same market participants is focused more on trying to explain the “vagaries and vicissitudes” (i.e. volatility of the stock market and changing opinions) of the markets ups and downs over the course of the week.  Furthermore, many commentators and guests try to explain why the predictions on Monday did not or did match up with the ideas expressed at the beginning of the week.

The overall point of this experiment was to “drive home” the fact that trying to time the market or predict its direction over the short term is extremely challenging and can seem hopeless.  Toward the end of December, the general investment thesis for the majority of money managers was that the stock market was poised to have a very positive January due to the fact that the financial markets did not really dive after the Federal Reserve announced the reduction of the tapering program, commonly referred to as QE (quantitative easing).  Additionally, the main belief was that bonds were one of the least attractive investments to own.  Most people assumed that the 10-year US Treasury Note was headed up to the 3.0% level.  Things seemed pretty simple and not too many headwinds in the near future.  So what happened during January?

The main event that most people remember was the currency difficulties of a number of emerging market countries.  The financial media focused a lot on the Turkish lira (TRY) and the Argentine peso (ARS).  Turkey had political problems, and Argentina has a huge problem as it relates to political leadership (or the absence thereof) and dwindling currency reserves.  There were other currencies that experienced trouble as well like the South African rand (ZAR).  The other important development was that the Japanese yen (JPY) reversed its direction and strengthen versus the US dollar (USD).  Oddly enough, the Argentine Merval stock index was one of the best performers over the course of the month.  No one saw this coming to such an extent.  You might term this an exogenous event as anything that occurs outside of your current model to build a portfolio or invest in individual stocks/bonds.  It is largely unknown and hard to predict.  (As an aside, this is NOT the same thing as a “black swan”.  That term is overused and conflated with many other things.  Refer to Dr. Nassim Taleb for a further definition of the termed that he famously coined years ago).  These events tend to be unknowns and have a greater impact because the general level of the perception of risk changes almost instantly and affect market sentiment and momentum.  Market participants need to alter their models rather quickly in order to account for the occurrence of these events.

The other big event was the movement of the yield on the 10-year US Treasury note.  Instead of following a general path of rising, the interest rate actually fell.  The yield on this instrument drifted down roughly 40 basis points (0.4%) from the 3.0% level.  What most people fail to realize is that interest rates go down if economic data turns out to be worse than expected normally (e.g. December jobs of 70,000 and the lowest labor force participation rate since the 1980s), but, more importantly, there is a “flight to quality” phenomenon that occurs over and over again.  There tends to be a bit of a “mini panic” when unexpected and impactful events occur.  If all else fails, institutional investors like hedge fund managers tend to buy US Treasury bills, notes, and bonds for safety.  The additional demand causes bond prices to go up and, by definition, yields will go down.

The combination of bad economic data and dealing with the currency woes in the emerging markets causes many short-term traders and speculators to buy these risk-free assets and figure out how to trade later.  It is sort of an example of reflexivity.  The bottom line for individual investors is that many sold bonds and purchased dividend stocks instead.  The exact opposite happened:  bond yields went down and dividend stocks sold off.  The worst short-term investing strategy was to search for yield in the stock market rather than the bond market due to rising interest rates.  For more information you can refer to one of my former posts on how to look at the various risk factors associated with bonds.  Trust me, there is a lot more to bonds than simply interest rate risk.  Here is the link to a former blog post that addresses this very issue:

https://latticeworkwealth.com/2014/01/02/a-bond-is-a-bond-is-a-bond-right-should-you-sell-bonds-to-buy-stocks/

There were many other smaller events that happened over the course of the month that affected the general volatility experience in the financial markets.  At the end of the day, even the “experts” had a monumental task trying to explain all the macroeconomic events, currency movements, and interest rate implications throughout January.  If the task was so difficult for them, it is normally advisable for individual investors to not follow the market daily and get caught up in temporary “greed and fear” of traders and speculators.  Investment ideas and predications can change from day to day and even minute to minute in the short term.  It is much more important for individual investors to develop a long-term financial plan that will allow them to reach future financial goals.  You then blend that with your risk tolerance.  For example, how likely would you have been to sell the positions in your portfolio given the volatility experienced during the course of January?  An outlook of five years is normally a great start for that plan.  If you look out into the future with a longer timeframe like an annual basis in terms of adjusting the components of your asset allocation, you are less likely to constantly trade the securities in your personal portfolio.  The frenetic pace of traders/speculators and the volatility of the stock and bonds markets makes it seem that you MUST do something, anything!

If you would like to learn a bit more about behavioral finance, you can refer to this blog post from last year (note context of examples referred to is from August 2013 when the piece was published):

https://latticeworkwealth.com/2013/08/04/todays-news-should-prompt-you-to-adjust-your-entire-investment-portfolio/

One of the most important things to learn in investing is how to control your emotions.  It is easy to map out your investment strategy and risk tolerance on paper.  Many asset managers who have experienced a multitude of secular bull and bear markets refer to this phenomenon as your EQ versus your IQ.  Thus, when actual “money” is involved, volatility and uncertainty in the financial markets brings forth challenges that even the best money managers have a hard time keeping up their nerve.  The other takeaway is that people’s investment recommendations can change on a dime.  Market participants can be very hopeful on one day and think the sky is falling the next day.  Trying to time the market is so difficult that you end up developing a portfolio allocation for your investments that assumes that general events with transpire.  All the planning in the world cannot account for all possibilities of geopolitical and global events that might really cause the market to go down more than normal in a short time period.

The whole point of this “thought experiment” was to encourage you to take a long-term view of investing in the financial markets.  It is a lot less stressful, less complicated, and tends to lead to better overall investment returns (i.e. you do not “sell low and buy high” as much because everyone tells you to).  For more information on stepping back and thinking about the long term, I have included a final blog post.  You always need to remember that your financial professional (or yourself if you manage your own investments) who advises you about investment decisions is forever impacted by the start of their investment career.  They tend to be biased and make investment recommendations based upon how things used to be when they started in the business.  It is very hard to separate your “biases” from the present day.  Here is the link:

https://latticeworkwealth.com/2013/08/18/before-you-take-any-investment-advice-consider-the-source/

Well, I hope you learned a few things by participating in my experiment and maybe even had a little bit of fun.  Please feel free to leave a comment or send me an email directly at latticeworkwealth@gmail.com with more specific feedback and/or questions.  Sometimes you can learn a great deal just by being an observer of financial market volatility.  What is the nothing part of this learning journey?  The moral of the story is that everyday guests appearing on CNBC or other commentators will let you know that the stock market with either go up, go down, or stay unchanged.  Obviously everyone knows that simple concept to begin with.  Thus, it is hard to choose who to listen too because of so many divergent opinions.  Lastly, you should realize that this same experiment would have worked with the other business networks and large financial news publications like the Wall Street Journal, Financial Times, Barron’s.

A Bond is a Bond is a Bond, Right? Should You Sell Bonds to Buy Stocks? – Supplementary Information on How Bonds Work

02 Thursday Jan 2014

Posted by in asset allocation, bonds, business, Consumer Finance, Education, Fed, Fed Taper, Fed Tapering, Federal Reserve, finance, financial planning, Individual Investing, interest rates, investing, investments, personal finance, portfolio, rising interest rate environment, rising interest rates, risk, statistics, volatility

≈ 1 Comment

Tags

, , , , , , , , , ,

How do bonds work in terms of prices?  Most bonds are issued at a price of 100 which is referred to as par.  Corporate bonds and Treasury notes/bonds are usually sold in increments of $1,000, and municipal bonds are sold in increments of $5,000.  The value of a bond is calculated by taking the current price divided by 100 and then multiplied by the number of bonds you own.  Bonds are sold in the primary market (when first sold to retail and institutional investors) such that the coupon (interest rate) is equal to the current interest rate prevailing in the marketplace at that time (sold at par which is 100).  Bonds can be bought and sold after that issue date though.  If interest rates rise or fall after issuance, how does the price of a bond adjust?  If interest rates go up, bond prices will go down.  If interest rates go down, bond prices will go up.  Why?  It is referred to as an inverse relationship.  Think about it this way.  If you own a bond that has a 6% coupon and interest rates rise to 8%, will you be able to see that bond to other investors?  The answer is no if you decide to hold firm to a price of 100.  Why should another bond investor buy a 6% bond when he/she can just buy a bond with very similar characteristics as yours and earn 8%?  The only way that you can sell your bond is to lower the price such that the bond investor will earn 8% over the course of that bond’s life until maturity which is when the company or other entity has to pay the money back in full).  Luckily for you, the process works in reverse as well though.  If interest rates go down to 4%, you have the advantage.  If you hold a bond with a 6% coupon as in the aforementioned example, bond investors will pay more than 100 in order to get that higher interest payment.  How much more?  Bond investors will bid the price up until the bond earns an equivalent of 4% until maturity.  Why is this important to you as an investor today?

Let’s take a quick look at history.  Most financial professionals are not old enough to remember or have been in business long enough to remember the interest rate environment back in the early 1980s.  In the early 1980s, interest rates on bonds were incredibly high compared to today.  The economy was stuck in a rut of higher inflation and low or no growth which was called “stagflation”.  How high were interest rates?  The interest rate on a 3-month Treasury bill was 16.3% back in May 1981, and the prime rate topped out around 20.5% soon after.  For more information on the interest rates of this time period, please refer to this link:  http://www.mbaa.org/ResearchandForecasts/MarketEnvironment/TreasuryYields&BankRates,1980-83.htm. The Federal Reserve chairman back then, Paul Volcker (Fed chairman prior to Alan Greenspan and the same gentleman as the so-called “Volcker rule” of today), instituted a monetary policy based upon the teachings of the famous economist, Milton Friedman, from  the University of Chicago.  Friedman was really the start of monetarism.  Monetarism is simply the effect of the money supply in any economy on interest rates.  In general, as more money in the economy is available, interest rates will go down.  As less money is available, interest rates will go up.  Why?  Think about it in this manner.  If you have to get a loan from a family member and you are the only person asking for a loan, chances are your interest rate will be lower than if that same family member is asked by 15 different individuals.  So the Fed of that time period began buying all types of bonds on the open market.  The hope was that, as the money supply grew, interest rates would fall.  As interest rates fell, it would give more incentive to companies to take out loans to buy equipment and build plants and also to incent consumers to take out mortgages and buy homes or purchase consumer goods with credit cards.  Needless to say, the policy eventually worked.  It started what most refer to as the great bull market in bonds in roughly 1982.

There are only two ways you can make money when you own a normal bond.  First, you earn money from the coupon paid over the life of the bond.  Second, in a falling interest rate environment, you earn money by selling your bonds at a higher price.  Therefore, you can earn money from interest and capital gains.  In a rising interest rate environment, you can only earn money from the coupon.  What individual investors, and some money managers even, fail to realize is this simple fact of finance.  The yield on a 3-month US Treasury bill today is roughly 0.06%.  No, that is not a misprint!  The yield on these bills has gone down over 16% over the past 30 years or so.  The bond market has never seen such an extended period of falling interest rates.  Now interest rates did not fall in a straight line, but the trend has been toward lower interest rates for decades now.  That anomalous occurrence is coming (has come) to an end.

A Bond is a Bond is a Bond, Right? Should You Sell Bonds to Buy Stocks?

02 Thursday Jan 2014

Posted by in asset allocation, bonds, business, Consumer Finance, Education, Fed Tapering, Federal Reserve, finance, financial planning, Individual Investing, interest rates, investing, investments, MBS, personal finance, portfolio, rising interest rate environment, rising interest rates, risk, statistics, stocks, volatility

≈ 1 Comment

Tags

, , , , , , , , , , , , , , , ,

I have heard over and over from financial pundits toward the end of last year and now 2014 coverage in financial publications that the great rotation of investors from bonds to stocks is finally occurring.  While there is definitely heavy selling of bond mutual funds going on, the bond market is actually quite complex.  The main reason why Financial Advisors are recommending that individual investors sell bonds is that interest rates are likely to rise over the next 3-5 years or more.  Well, I would agree that interest rates are poised to rise.  However, interest rate risk is only one of the risks of bonds.  In fact, the size of the bond market dwarfs the stock market.  When Financial Advisors are talking about bonds, they tend to be referring only to Treasury bonds, corporate bonds, and municipal bonds.  Interest rate risk greatly affects these bonds.  With that being said, they tend to conflate the interest rate risk of these bonds with the entire bond market.  Remember that interest rates have dropped from 16.30% on the 1-month US Treasury bill back in 1981 to roughly 0.05% today.  Therefore, bond prices have been rising for over 30 years and most financial professionals outside of the fixed income markets have forgotten (or if they are younger than 50) how bonds normally work, especially in a rising interest rate environment.  But does it even matter really?

Yes.  Here is an urgent note to all individual investors:  “Beware of financial professionals that recommend dividend stocks or other equities as replacements for your fixed income allocation”.  What I mean by this is that the volatility of stocks is far greater than bonds historically.  Yields may be very low in money market funds, US Treasuries, and in bond mutual funds now.  However, your risk tolerance must be taken into account at all times.  While it is true that many dividend-paying stocks offer yields of 3% or more with the possibility of capital appreciation, there also is significant downside risk.  For example, as most people are aware, the S&P 500 index (which represents most of the biggest companies in America) was down over 35% in 2008.  Many of those stocks are included in the push to have individual investors buy dividend payers.  With that being said, stock market declines of 10%-20% in a single quarter are not that uncommon.  If you handle the volatility of the stock market well, there is no need to be concerned.  However, a decline of 10% for a stock paying a 3% dividend will wipe out a little more than 3 years of yield.  Individual investors need to realize that swapping traditional bonds or bond mutual funds is not a “riskless” transaction, meaning a one-for-one swap.  The volatility and riskiness of your portfolio will go up commensurately with your added exposure to equities.  Sometimes financial professionals portray the search for yield by jumping into stocks as the only option given the low interest rate environment.  While your situation might warrant that movement in your portfolio allocation, you need to be able to accept that the value of those stocks is likely to drop by 10% or more in the future just taking into account normal volatility in the stock market historically (12-36 months).  Are you able to handle that volatility when looking at your risk tolerance, financial goals, and age?

The purpose of this blog post is to discuss the risk factors associated with bonds in greater detail.  I have already spoken about this at length in posts last year.  Most bonds, such as Treasury notes and bonds, corporate bonds, and municipal bonds, will go down in value when interest rates go up.  Conversely, they will go up in value when interest rates decrease.  This characteristic of these types of bonds is called an inverse relationship.  For a primer on how most bonds function normally, I have posted supplementary material alongside this post.  You can refer to it to brush back up on bonds and how they work, and I also provide a historical look at interest rates over the last 30 years.

 

There are many risk factors associated with investments in bonds.  A great overview of those risks can be found in Fixed Income Mathematics the Fourth Edition by Dr. Frank Fabozzi who teaches at Yale University’s School of Management.  Most fixed income traders, portfolio managers, and risk managers use his Handbook of Fixed Income Securities as their general guidebook for approaching dealing with the trading, investing, and portfolio/risk management of owning fixed income securities.  Suffice it to say that he is regarded as one of the experts when it comes to the bond markets.  Dr. Fabozzi summarizes the risks inherent in bonds on page 109 of the text referenced above.  The risks are as follows:

1)       Interest-rate risk;

2)      Credit risk;

3)      Liquidity risk;

4)      Call or prepayment risk;

5)      Exchange-rate risk.

Most of fixed income folks and myself would add inflation risk, basis risk, and separate credit risk into two components.  Bonds have two types of risk as it relates to payment of principal and interest.  The first risk is more commonly thought of and referred to as default risk.  Default risk is simply whether or not the company will pay you back in full and with timely interest payments.  Credit risk also can be thought of as the financial strength of the company.  If a company starts to see a reduction in profits, much higher expenses, and drains of cash, the rating agencies may downgrade their debt.  A downgrade just means that the company is less likely to pay back the bondholder.

Here is an example to illustrate the difference more fully:  a company may have a AA+ rating from Standard & Poor’s at the beginning of the year, but, due to events that transpire during the year, the company may get downgraded to A- with a Negative Outlook.  Now the company is still very likely to pay back principal and interest on the bonds, but the probability of default has gone up.  As a point of reference, AAA is the highest and BBB- is the lowest Standard & Poor’s ratings to be considered investment grade.  You will note that the hypothetical company would need to be downgraded four more times (BBB+, BBB, BBB- to BB+) to be considered non-investment grade or a “junk” bond.   Bond market participants though will react to the downgrade though because new potential buyers see more risk of default given the same coupon.  So even though the company may not default eventually on the actual bond, the price of the bond goes down to compensate for the interest rate required by the marketplace on similarly rated bonds to attract buyers.

Now I will address the full list of risks affecting bonds outlined by Dr. Fabozzi above.  Any bond is simply an agreement between two parties in which one party agrees to pay back money to the other party at a later date with interest.  All bonds have what is referred to as credit (default portion) risk.  Credit risk in general is simply the risk one runs that the party who owes you the money will not pay you back (i.e. default).  What is lesser known or thought about by individual investors is interest-rate risk and inflation risk.  These two risks are usually missed because investors tend to think that bonds are “safe”.  Interest-rate risk relates to the fact that interest rates may rise, while you hold the bonds.  When financial pundits make blanket statements about selling bonds, they are referring to this one risk factor normally.  Inflation risk means that inflation may increase to a level higher than your interest rate on the bond.  Thus, if the interest rate on your bond is less than inflation or closer to inflation from when you bought the bond, your purchasing power goes down.  The prices of goods and services go up faster than the interest you earn on the bond.  Call risk refers to instances where some companies have the option to redeem your bonds in the future at an agreed upon price.  Prepayment risk is a more specialized case of call risk and refers to people paying their mortgages (or credit cards, home equity loans, student loans, etc.) back sooner than expected.  Most people group these two risks into a category called reinvestment risk.  Think about the concept in this manner:  many people refinanced their mortgages because interest rates went down.  They did so because they could lower their total mortgage payment.  Well, companies do the same thing if they have the option.  Companies can redeem bonds at higher interests and issue new bonds at lower interest rates.  Chances are that, if you are the owner of the redeemed bonds, you will be unable to find as high of an interest payment currently if you want to buy a bond with similar characteristics of the company issuing the bonds you own before.

The other three risks I mentioned above are less commonly discussed and not quite as important.  Exchange-rate risk exists because sometimes a company issues bonds in a currency other than its own.  For example, you will sometimes hear the terms Yankee bonds or Samurai bonds.  Since the company is paying you interest and principal in a foreign currency that money may be worth more or less depending on what happens in foreign exchange markets in the future.  Liquidity risk refers to the phenomenon that there are certain crisis times in the market where very few, if any bond market participants, are willing to buy the bonds you are trying to sell.  Therefore, you might have to take a bigger loss in order to entice someone to buy the bonds given the current macro environment.  Basis risk is a more obtuse type of risk that institutions deal with.  Basis risk essentially refers to anytime when interest rates on your bond are pegged to another interest rate that is different but normally behaves in a certain way (referred to as correlation).  Now most of the time, the behavior will follow the historical pattern.  However, during times of stress like a liquidity and/or credit crisis, the correlations tend to break down.  Meaning you can think you are “hedged” but, if the historical relationship does not hold up, your end return will be nothing like what you had expected.  These two risks are not something that individual investors need to focus on.

I will admit that this list is quite lengthy and, quite possibly, a bit too detailed and/or complicated.  However, I wanted to lay them all out for you.  Why?  When you hear Financial Advisors recommend that you sell a large portion of your bonds, and/or hear the same investment advice from the financial media, they normally are really only referring to interest-rate risk primarily and secondarily inflation risk as well.  As you can see from the description above, the bond market is far more complex than that to make a blanket statement.

As I usually say, I would never advise individual investors to take a certain course of action in terms of selecting specific bonds or not selling bonds to move into more stocks.  However, I am saying that you should feel comfortable enough to ask your Financial Advisor why he/she recommends that you sell a portion of your bonds.  If the answer relates only to interest-rate risk, I would probe the recommendation further.  You can explain that you know that is the case for Treasury notes/bonds, municipal bonds, and corporate bonds.  However, there are a whole host of other fixed income securities with different characteristics and risks.  Now I am not referring solely to Mortgage Backed Securities (MBS), although the residential and commercial markets for these are in the trillions of dollars.  There are bonds and notes that have floating interest rates which means that as interest rates go up, the interest rate you receive on that security goes up.  Not to mention that different countries are experiencing different interest rate cycles than the US (stable or downward even).

The complete list is too in-depth to cover in a single blog post.  My goal was to provide you with enough information to at least ask the question(s).  Your risk tolerance and financial goals might make a move from bonds to stocks the best course of action.  With that being said, you also have the option of selling bonds and keeping the money in cash or investing in the different types of bonds offered in the fixed income markets while keeping your total allocation to fixed income nearly the same.  Thinking holistically about your portfolio, you may be increasing the riskiness of your portfolio beyond your risk tolerance or more than you are aware unbeknownst to you by moving from bonds into stocks.  This is something you definitely want to avoid.    It can turn out to be a rude awakening and hard lesson to learn one or two years from now.