It's All Relative

IN THIS EDITION

In this edition of PIM’s Quarterly News Release, we discuss: 1) Relative Investment Return, 2) Valuations, 3) The Bond Market.

The Bond Market narrative is a much longer, more detailed presentation than we have ever delivered.  Bond market returns this year have been the worst in decades.  Our goal is to explain how this market works, the reasons for this year’s performance, and our fixed income portfolio management strategy.  We hope you find this understandable and useful.

IT’S ALL RELATIVE

Absolute return is the percent by which investments are up or down in a given period.  This year, absolute returns are negative across the board.  Inflation is the primary culprit.

Relative return is investment return compared to something else, usually “the market”, defined as some combination of asset class benchmarks.  At the portfolio level, determining relative return requires the composition of a blended benchmark portfolio for each level of portfolio risk. 

PIM clients’ investment and retirement assets reside at three different custodians (Charles Schwab & Co, Fidelity and TIAA), in various combinations, based upon employment status and other factors.  At Fidelity and TIAA, PIM clients’ accounts hold investments chosen from limited menus of available options.  Additional factors influencing investment outcomes include the timing of contributions and distributions from investment and retirement accounts. 

Another, less scientific, way of considering relative return is by comparing investment outcomes to financial needs, expectations, and peace of mind during turbulent times.  And turbulent times, these are.  Year-to-date, through September 30, here are the total returns of the main asset class benchmarks.

We have employed various risk-mitigation strategies this year, depending upon custodian, to generally good effect.  When considering your absolute investment return for the year, as presented in your quarterly performance report, do so relative to the asset class returns presented above and relative to your tolerance for volatility.  This is a very good time to consider the appropriateness of your risk profile.  This is not a particularly good time to make a change to a more conservative investment model, but doing so after the market recovers could certainly be appropriate.  If this topic feels timely, please contact your PIM Financial Advisor for a discussion.  

MARGIN OF SAFETY

Margin of Safety is a classic book in the finance industry written by hedge fund legend Seth Klarman.  The book is out of print and will set you back a cool $1,000 for a hard copy, but one can find a PDF copy for free online.  The book is full of the kind of insights that encourage multiple readings over years without being overly technical.  The premise is how to manage risk across different assets and through different types of markets.  In many ways, it’s a continuation of Graham and Dodd's Security Analysis, a book Warren Buffett considers his roadmap for investing over the past 57 years.

The goal of Margin of Safety is to help investors find situations where the odds of success are tilted in their favor.  Klarman’s book is a framework for discovering investments that the market is willing to sell for a price well below the asset’s intrinsic value, even in the worst-case financial scenario.  In today’s market Klarman’s lessons are very timely.  The plumbing of the global financial system is creaking under the weight of higher interest rates, wildly volatile currencies and falling equity and bond prices.

At 3585, the S&P 500 is now at the same level as it was in November of 2020.  Doom and gloom are pervasive.  The Bank of America bull/bear indicator is currently zero out of a possible 100, in favor of the bears.  Hedge fund and other fast money investors have 0-5% of normal equity exposure.  If you’re a contrarian investor waiting for an environment where positioning and sentiment are as low as possible, you’re in it.

The rapid fall in capital assets means that valuations have also changed significantly.  A great deal of bad news has been incorporated into equity and bond prices.  Certain areas of the equity market, such as energy, healthcare, financials, and materials are trading at deflated valuations not seen in more than ten years.  Overseas, the main Chinese index for Western investors (Hang Seng) is at its lowest valuation ever.  European industrial equities are less expensive today than during the Euro crisis of 2010.  In the bond world, yields on ten-year Treasuries briefly touched 4% for the first time in twelve years.  2022 has been a struggle, but we’ve stayed defensive and avoided the brunt of the decline in our portfolios.  It’s important to realize that the general decline in capital assets has produced a healthy “margin of safety” for certain areas of the market.

Finding attractive valuations is an important aspect of successful investing, but the market will be challenged without a catalyst to move assets prices higher.  A sustained break in inflation is the obvious candidate.  The data on this front is positive, but skepticism is warranted as we’ve experienced three inflation head fakes this year.  Several inflationary hot spots are showing weakness: commodity prices, shipping costs, used car prices, rents and home prices are all moving down by various degrees.  It does take time for these higher frequency datapoints to be incorporated into the official inflation numbers, but the trend is moving in the right direction.  On the downside, the labor market remains strong and energy prices appear to have recovered.  We are likely several months away from a sustained break in inflation and a more accommodative Federal Reserve. 

We may see continued pressure across all markets as the path of interest rates, earnings and inflation comes into sharper focus.  In the meantime, we are positioned to weather the storm and take advantage of the opportunities the market presents.  From our standpoint we are encouraged that we can find attractive assets priced at levels we haven’t seen in a decade.  Finding a margin of safety is the first step to forming a market bottom.

BOND MARKET 101

The performance of the bond market has a significant impact on PIM clients’ investment returns.  The more conservative the client, the greater the impact.  As of the end of the 3^rd quarter, the bond market is down 14.5% for the year, on track to be the worst year for the aggregate bond index since inception in 1977.  This seems an appropriate time to develop at least a basic understanding of this market.

The Stock Market           

The stock market is generally understood.  People buy stocks to participate in the future growth of the issuing company.  Stocks are traded in auction-style markets.  There is always a buyer on one side of a stock transaction and a seller on the other.  These two parties may have differing views on the growth prospects of the company.  When stocks go down, there are more sellers than buyers.  When stocks go up, there are more buyers than sellers. The combined value of all stocks listed on US exchanges was approximately $57 trillion, at the end of 2021.

What is a Bond?

A bond is a debt obligation, a “debenture” in regulatory filings.  An entity bringing a bond to market is asking the investing world for a loan.  Bond buyers are lending money to the issuer.  With traditional bonds, investors are promised a return of their principal investment at the maturity of the bond and periodic interest in the interim (commonly referred to as coupon payments).  The original buyer of the bond can sell the bond in the open market before maturity.  The new owner then becomes entitled to the accompanying periodic interest payments and principal repayment at maturity.

The Bond Market

Bond market activity is quoted in yield, not price, which is eminently confusing.  If you see on a given day that the Dow Jones Industrial Average was up 200 points and the yield on the 10-year treasury was up .25%, you probably understand the first data point but may not understand the second.  An increase in yield means a decrease in price.  So on this day, the stock market was up, and the bond market was down.

Most bonds, other than U.S. Treasuries, don’t trade very often.  When they do, it is through a brokered market.  There is no central exchange for bonds.  An investor seeking a specific bond might call ten different dealers looking for the right bond at the right price.

Another key difference between the equity and bond markets is that a company will generally have one equity (stock) trading on the open market but potentially many different bonds outstanding.  The stock ticker symbol for Ford Motor Company, for example, is “F” and only “F”.  Whether you bought shares of Ford twenty years ago or last week, all your shares represent the same financial instrument, trade for the same price, and earn the same dividend.  However, Ford has approximately 500 different bonds outstanding.  All these bonds were issued at different times in the past, have maturity dates at various points in the future, and pay different coupon rates.  Due to these variables, prices of Ford bonds range from 115 (15% over issue price; this bond is selling at a premium) to 71 (29% under issue price; this bond is selling at a discount).

The bond market is larger than the equity market. The combined value of all debt issued in the U.S. was approximately $90 trillion, as of the end of 2021.

Who Issues Bonds?

The three general categories of bond issuers are: 1) U.S. Government, 2) Municipalities, 3) Corporations. 

The U.S. Government issues the following Treasury securities:  1) T-Bills, with maturities of one year or less, 2) Treasury Notes, with maturities of 10 years or less, 3) Treasury Bonds, with maturities of 20 or 30 years, and 4) Treasury Inflation Protected Securities, with maturities of 5, 10 or 30 years. The U.S. Treasury sells new T-bills, Notes and Bonds on a regular basis at auction, depending on funding needs.

Two US government agencies (Fannie May and Freddie Mac) issue large quantities of mortgage-backed bonds to support home ownership and the financing of multi-family buildings.  These bonds pay the holder both principal and interest monthly, unlike traditional bonds described above, which generally pay interest semi-annually.  Think of holders of these bonds as the recipients of a portion of your monthly mortgage payment.  If you’ve ever had a conventional fixed-rate mortgage, it’s almost certain that your mortgage was part of a mortgage-backed security sold to investors.

Municipalities, such as states, counties, and cities, issue “municipal bonds.”  There are two main types of municipal bonds: 1) General Obligation Bonds, the proceeds from the sale of which are for general use, and the repayment of which is based upon the taxing authority of the issuing municipality, and 2) Revenue Bonds, the proceeds from the sale of which are used to build something that is expected to be revenue-generating, such as a civic center or hospital.  The repayment of these bonds comes from the revenues generated by the completed project.  Interest payments from most municipal bond issues are federally tax free. 

Corporations issue bonds to raise money for any number of reasons ranging from the construction of a factory to purchasing a competing firm, or simply for general operations.  Financial firms such as banks and credit card companies are the largest issues of corporate bonds.

Sectors of the Bond Market

The benchmark index for the US bond market is the Bloomberg Barclays Aggregate Bond Index; data for this benchmark was initiated in 1977.  An easily trackable ETF for this index is the iShares Core U.S. Aggregate Bond ETF, ticker: AGG. The “AGG” consists of U.S. Government Bonds, Municipal Bonds, investment-grade Corporate Bonds and Securitized Bonds issued by government agencies.  The index is weighted by the size of the bond issue relative to the overall bond market.  Roughly 70% of the AGG is U.S. Treasuries and mortgaged-back securities.

There are many types of bonds that are not included in the AGG, such as foreign government and foreign corporate bonds, floating rate and non-government backed securitized bonds. These non-benchmark bonds are sometimes used in our fixed income allocations.

Bond Ratings

Large bond issues generally carry a rating from one of the main three rating agencies: Standard & Poor’s, Fitch, and Moody’s.  Each agency has ten different ratings, from best to worst, within the investment grade category.  And each has ten different ratings, from best to worst, within the non-investment grade category.  Each has ratings specifically for issuers who are very likely to default or already have defaulted.  S&P and Fitch use the same letter system.  For example, the top of the investment grade bond range is assigned a AAA rating and the bottom of the investment grade range is rated BBB-.  Moody’s uses Aaa through Baa3 to reflect the same opinions.

The main distinction worth noting is investment grade versus non-investment grade (called “high yield”, or “junk”.)  High yield bonds have higher coupons to entice investors and compensate for the additional risk of ownership. 

Investors in bonds need to manage two primary factors: credit risk and interest rate risk.  Bond ratings support the credit risk part of the process, with one primary limiting factor.  Financial conditions may move (deteriorate) faster than a rating agency can track.  Therefore, in times of economic stress, ratings may become quickly outdated and of little use. 

Interim Pause and Summary

• The bond market is larger than the stock market.
• Bonds are debt obligations of the issuer. The owner of a bond is entitled to repayment of principal at maturity and periodic interest payments along the way.
• The U.S. Government, States, Municipalities and Corporations are the primary issuers of bonds.
• The category Securitized Bonds, a large segment of the overall bond market, is comprised primarily of mortgage-backed securities.
• Large bond issues are usually rated by one of three rating agencies. The main categories are: Investment Grade, Non-Investment Grade, In/ Near Default.
• Bond ratings inform the buying public of the default risk associated with the bond.

Defining Risk (performance variability)

The main sources of risk at the portfolio level are interest rate risk and credit risk.  These risks can be measured by the price volatility of the underlying bonds in the portfolio. 

Standard Deviation is one generally accepted measurement of risk in finance.  It represents the extent to which the price of an investment varies around its own average price over given periods of time.  Investors often consider the fixed income portion of their portfolios to be safe and stable.  And historically this has been true.

As of August 31^st, 2022, the 10-year standard deviation of the S&P 500 (SPY) was 14.  Over the same period, the standard deviation of the bond market (AGG) was 3.67.  Over this ten-year period, the bond market was only about 26% as volatile as the S&P 500. 

Over the prior 3 years, the standard deviation of the S&P 500 was 19.36, and the standard deviation of the bond market was 4.77.  While elevated, the ratio remains fairly constant.

Interest Rate Risk

We have discussed this before, and it is a bit tricky.  Let’s say that two years ago, you bought a high-quality bond with a 2% coupon and ten years to maturity.  And let’s say that now, because interest rates have gone up, a bond of similar credit quality with the same maturity date has a coupon of 3%.  If you wanted to sell your bond today, you could certainly do so, but you would have to accept a discount to what you originally paid.  Why would someone pay you full price for a high-quality bond with eight years to maturity and a 2% coupon when a bond with like credit quality and maturity is available that pays 3%?  They wouldn’t.  The buyer of your 2% bond needs the same total return that is provided by the 3% bond so will pay you less for yours to accomplish this.  In a nutshell, this is interest rate risk.

Interest rates have jumped dramatically because of the Fed’s inflation mitigation strategy, and the value of bonds has gone down accordingly.  This is one of the two primary reasons the bond market is having its worst year in decades.

The Yield Curve  

The yield curve is a representation of prevailing interest rates on short-term bonds, intermediate-term bonds, and long-term bonds.  Commentary about the yield curve usually includes phrases such as bull/bear steepening or flattening, twists, shifts, inversions, butterflies and kinks.  A normal yield curve reflects that the lowest yield is being paid on short maturity bonds, higher for intermediate-term and highest for long-dated bonds.  This makes sense.  The longer an investor is willing to allow their money to be tied up, the more interest they should earn to compensate for the risk of owning the bond. 

The yield curve is not always “normal”, in fact it’s rarely normal in practice.  The reasons for this go beyond the scope of this commentary, but generally speaking the shape of the curve reflects investors’ views of the strength of the overall economy, inflation, monetary policy, and market liquidity.

This illustration taken from Morningstar Direct at the end of the 3^rd quarter shows an inverted curve; the yield on a six month and two-year Treasury is 4.22%, while the yield for the ten-year Treasury is 3.83% and the yield for a 30-year Treasury bond is 3.79%.  Investors are being paid more to own a six-month Treasury than a 30-year Treasury.  

Interim Pause and Summary (2)

• The two primary risks associated with bonds are credit (default) risk and interest rate risk.
• Investment managers are also concerned with daily volatility and typically use standard deviation when modeling portfolios.
• Using standard deviation, the bond market has historically exhibited approximately 25% of the volatility of the S&P 500.
• The yield curve is a graphical representation of prevailing interest rates on short-term bonds all the way to long-dated bonds.
• The yield curve is not always normally shaped. Investors modify the composition of their bond holdings based upon their views on inflation, the state of the economy and monetary policy.
• In a rising interest rate environment, not all bonds experience the same degree of price depreciation. Shorter term bonds are less impacted.  Long-term bonds are most impacted. Many caveats apply to this generalization.

The Bond Market in 2022

2022 has easily been the worst year for bonds since the inception of the AGG in 1977.  Prior to this year, the worst rolling twelve-month performance for the AGG was -5.7%.  The worst annual performance was in 1994 at -2.94%.  The market is on track for -14.5% in 2022.  We’ve written that the first four months of the year were the worst four months in the Treasury market since the Civil War.  For as much press as the equity market has received this year due to its poor performance, it really doesn’t compare to the damage done in the fixed income market.  There are two primary reasons for this.

Monetary Policy / Supply & Demand

The bond world has been heavily influenced by central bank monetary policy over the past few years.  This year, we have moved from pandemic-era easy money to inflation-fighting tightening in rapid succession.   

As recently as March, the Fed was buying U.S. Treasuries and mortgage back securities through its Quantitative Easing (QE) program (part of the “easy money” strategy).  At its height, the program was purchasing $120 billion in assets monthly.  When the Fed buys Treasuries in large quantities, prices naturally rise, and yields fall.  This is the basic supply/ demand market dynamic that would apply to any good or service.  The Fed is now undergoing Quantitative Tightening (QT), which should have the opposite effect.

The Treasury still needs to issue bonds to replace those that mature, but now the Fed is not standing in line to buy.  The result of lower Fed participation is lower demand, which contributes to lower bond prices (and therefore higher yields).  Compounding the problem, the Fed stepped back just as two other large buyers of Treasuries have retreated.  Both Japan and China (the two largest holders of US debt) have been actively lowering their exposure to Treasuries for various reasons this year.  Less demand from deep pocketed central banks means, all else equal, lower prices and higher yields on Treasuries.

Before moving on, a quick detour to distinguish between the Fed and the U.S. Treasury, lest we leave the impression that the Fed is buying its own bonds.  The Federal Reserve is the central bank of the United States.  It has two mandates: price stability (controlling inflation) and creating the economic conditions for a robust employment market (controlling unemployment).  The U.S. Treasury has many roles.  Directly from its website: “The Department of the Treasury operates and maintains systems that are critical to the nation's financial infrastructure, such as the production of coin and currency, the disbursement of payments to the American public, revenue collection, and the borrowing of funds necessary to run the federal government.”  It is this last point that we wish to highlight.  The U.S. Treasury sells bonds.  When the Fed is a buyer of these bonds, it is literally lending money to the U.S. government for its regular operations. 

Inflation-Fighting Rate Hikes

The second major aspect of poor bond market returns is the simple fact the Fed has increased short-term borrowing costs (the overnight rate) from zero to 3.00% since March of this year.  Historically, this is an extreme pace.  When you start near zero, any increase is large in percentage terms; the yield on the three-month T-Bill has increased 8,225% in one year.  Treasuries are the reference point for all other fixed income instruments.  Their poor performance means every other type of bond will also struggle to varying degrees.  The investment grade corporate bond index is down 21.24%, the Muni bond index is down 10.64% and the High Yield index is down 16.2%.  High Yield was down 26% during the financial crisis, but otherwise these are the worst annual return figures since 1977.  

Interim Pause and Summary (3)

• This is the worst bond market in a generation.
• There are two primary reasons for 2022 bond market performance:
  • The Fed is no longer the large institutional buyer of Treasuries and mortgage-backed securities that it had been (and Japan and China are reducing their exposure to U.S. Treasuries).
  • Rising interest rates erode the market value of bonds.

PIM’s Approach to Fixed Income Portfolio Management

Managing the fixed income portion of all client portfolios, regardless of custodian, starts with considering interest rate and credit risk.  These are the two main drivers of portfolio performance.  If judgements in these two areas are sound, there is a reasonable chance of outperforming the bond market benchmark (AGG).  Before digging deeper, we need to explain the concept of bond duration.

When retail investors consider the date upon which their principal will be returned to them, they look at maturity, and naturally so.  Investment professionals largely ignore maturity in favor of a concept called “duration”.  Duration, theoretically, is the future date by which a bondholder will have been paid back their initial investment.  The variables in the duration calculation are maturity date and the cumulative amount of coupon payments.  The longer the duration of a bond, the greater its sensitivity to changes in interest rates. 

Going into 2022, after several years of easy monetary policies and low interest rates, the AGG had a duration of 6.5 years, meaning a 1% increase in interest rates would cause the AGG to fall by 6.5% in value, all else equal.  The long-term average duration of the AGG is 4.9 years.  In other words, the bond market held considerable interest rate risk early in the year.

PIM’s fixed income allocations have been underweight interest rate risk (duration), for quite a while, so we were somewhat insulated against a rising rate environment before it materialized.  To achieve this, we combine short-term bonds (with low sensitivity to interest rates) and long-term bonds (with high sensitivity to interest rates) in a ratio that equates to a specific duration target.  This strategy is commonly referred to as a “barbell”.  In February of this year, for accounts in custody at Schwab, where we have the greatest ability to select specific investments, we targeted portfolio duration of 3.5 years.  These fixed income portfolios are exposed to much less interest rate risk than the benchmark.

In terms of credit risk, we generally avoid high-yield or junk bonds.  If you have the potential to experience as much volatility as the equity market, you should have commensurate upside investment return potential.  Junk bonds, other than after periods of extreme selling pressure, rarely deliver equity upside despite their volatility.  It’s worth noting that junk bonds have less interest rate risk (generally shorter duration) but more credit risk (higher default rates) than investment grade bonds.  This lower interest rate risk is why junk bonds have outperformed investment grade bonds so far this year.  If the economy continues to slow through the remainder of the year and into 2023, which seems likely, we expect to see increased defaults and underperformance from the high-yield sector.

Our overall thought process for fixed income has been to underweight interest rate risk via duration management and avoid high yield bonds entirely.  This strategy has been generally correct so far this year and has resulted in our fixed income models outperforming the AGG.  Depending upon where client accounts are in custody (Schwab, TIAA, Fidelity), certain non-benchmark fixed income investments may be used.  Non-benchmark investments are bond categories that are not part of the AGG.  One significant example is physical real estate (loosely a bond proxy) available for accounts at TIAA, which has performed very well.  For accounts custodied at Schwab, the best performing non-benchmark investment has been securitized assets ranging from aircraft leases to bonds funding multi-family housing.

Outlook for the Bond Market

In an effort to get inflation under control, the Fed has been aggressive in raising interest rates this year.  On January 4^th, the yield on the two-year Treasury Note was 0.8%.  Today it is around 4.2%.  And the Fed isn’t done yet.  Current thinking is that the yield on the two-year will reach 4.5% or above before the Fed will pause to survey the impact of their work on the rate of inflation.

The effects of higher interest rates feed through the real economy with a “long and variable lag” of six to 18 months.  The impact of the rapid increase in the cost of borrowing is yet to be fully realized by businesses and consumers.  If financial conditions deteriorate, as forecasted, investment capital is likely to flow into high quality bonds.  As a traditional safe-haven, bonds (mainly Treasuries and investment grade corporates) will see greater investor demand and higher prices.  It is counter-intuitive perhaps, but this scenario is very bullish for fixed income.

As bad as the bond market has been in 2022, the outlook for fixed income is brighter than it has been in years.  Yields across many fixed income sectors are at decade highs (meaning prices at decade lows), even for those areas of the bond market with little to no credit risk.  New capital coming into the bond market will realize both much higher yields than in recent decades and the possibility of capital appreciation down the road, if/ when interest rates fall back.  

Final Summary

• The bond market is on track for the worst year in a generation, perhaps in any of our lifetimes. The two primary drivers of performance this year have been:
  • The Fed moving from quantitative easing to quantitative tightening, greatly reducing its open market purchases of Treasury and mortgage securities. At the same time Japan and China are lowering their exposure to U.S. Treasuries.  This is the basic supply/ demand dynamic.  Buyers back away, prices fall.
  • The Fed has initiated several interest rate increases, at record pace, to battle inflation. When interest rates go up, the market value of bonds goes down.
• PIM’s approach is commonly referred to as a “barbell” strategy. Our target duration this year has been 3.5 years, achieved via an appropriate weighting of short-term and longer-term bonds.  Where possible, we have used select non-benchmark investments to good effect. 
• The outlook for the bond market is encouraging. Most simply put, bond prices are down to an extent not witnessed by any person living today.  We can’t predict the timing, but there will be a recovery.  And when this occurs, we are likely to see outsized performance to perhaps rival the degree of underperformance we are living through now.

Closing Comments

This has been a longer, and perhaps more technical communication than we have ever delivered.  We sincerely hope that you found this to be understandable and informative.  This has been a tough year, to be sure.  Our view is that we are nearer the end of the bear market than the beginning.  Whatever the exact timing of the recovery, recover we will.  In the meantime, please reach out to your PIM Financial Advisor if you have any questions or concerns. 

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