Morningstar Advisor - August/September 2013 - (Page 36)
Spotlight
Diverse Crowd
By Hal Ratner
Because the fixed-income market is a dynamic, varied place,
bonds respond to rising rates differently.
Interest rates are on everyone’s mind. Positive
employment numbers, signals from the Federal
Reserve that it is entertaining winding down QE
III, a recovering housing market, and improving
consumer sentiment have sparked fear
of inflation and pushed rates up. Fund flows
emphasize the point. In June, for example,
investors pulled nearly $10 billion from PIMCO
Total Return Fund PTRRX, the largest outflows
in the largest bond fund’s history.
Indeed, things are improving, though perhaps
not much and not far beyond the borders
of the United States. The eurozone—the
world’s largest economy—is still struggling
with little evidence of near-term improvement.
With this global sluggishness, there seems
to be an upper bound on rates. Assuming away
exogenous events like a war or supply shock,
we will almost certainly not see rates climb to
the double-digit levels of the early 1980s.
That rates are on the rise isn’t surprising, if only
because they’ve been so low for so long.
The 2008–09 financial crisis left a real negative
interest-rate environment in its wake thanks
to a massive flight to safety and Olympian
efforts on the part of policymakers to
keep nominal rates low and liquidity high. In
fact, one can make the point that among
policy-makers’ goals was a reduction in
governments’ real borrowing costs—not just
keeping the “risk markets” (credit and equity)
afloat. So, while central banks like the Fed
(which doesn’t have an inflation target like the
European Central Bank) don’t want runaway
inflation, some inflation will erode real
borrowing costs. Additionally, because the
sheer presence of liquidity doesn’t necessarily
lead to inflation—you need velocity (activity)
not just money to make the economy go
round—an increase in economic activity is
likely to result in some inflation. Such inflation
would be a sign that things are improving.
However, we may not see rates back down
much either—the sheer supply of government
debt is likely to keep them above recent
lows. Given how low rates were at the start
of the year, even a small percentage-point
increase can be painful. Through July 5,
long-term Treasuries, as measured by the
Barclays Capital Long U.S. Treasury Index, were
down 10.4%. Treasury Inflation-Protected
Securities (which are long duration instruments
and had sported negative nominal yields
recently) were down more than 8%. The
comparatively diversified but still Treasuryheavy Barclays Capital Aggregate Bond Index
was down 3.5%. High-yield bonds, however,
were up about 1.4%.
36 Morningstar Advisor August/September 2013
In a nutshell, duration risk has been bad; credit
and equity risk has been good.
The Treasury yield curve has risen during this
year—in both nominal and real terms.
In January, the yield on the 5-Year Treasury
Constant Maturity Index was 81 basis
points. At the end of June, it stood at 1.2%.
If we use end-of-May, year-over-year CPI of
1.4% as a proxy for “expected inflation,” rates
were negative for maturities less than five
years. Negative real interest rates imply that
investors are paying to lend in purchasing
power terms. And we should emphasize that
1.4% is a very low number by historic inflation
standards. It’s more than 100 basis points
less than the 2.5% that many economists posit
the long-term equilibrium number to be.
(Negative rates could also imply extremely low
inflation expectations, and that the global
slowdown is for the long haul. There are also
technical factors at play here with central
banks and other institutionals unable or
unwilling to sell. Indexing is also a factor as
increased Treasury issuance has driven up their
presence in indexes and indexed funds.)
Holding real negative interest-rate investments
isn’t irrational. Investors are willing to pay
for the insurance that Treasuries can provide in
a risk-on/risk-off world. While the 2008
financial crisis may be receding into the past,
it has left a very long wake. Indeed, government-grade bonds remain expensive by historic
standards. This is doubtless a function of a
global economy that although better than it
was a few years back is still fragile. Even in the
Table of Contents for the Digital Edition of Morningstar Advisor - August/September 2013
Morningstar Advisor - August/September 2013
Contents
Contributors
Letter From the Editor
Under Pressure
Has Your View of Bonds Recently Changed?
The Simple Life Cuts a Path to Prosperity
How Extended Is Your Bond Fund?
A Bond Contrarian Scours the Globe for Value
Investments á la Carte
Investment Briefs
Bond Market Behemoths
Shopping in the Digital Age
Shopping in the Digital Age
Diverse Crowd
Motor City Meltdown
Bond Convergence
Corporates Are Fairly Valued, but Opportunities Will Arise
A Legend Still Pines for the Good Fight
Greener Pastures
Forecasting Market Bubbles and Crashes
Forecasting Market Bubbles and Crashes
Home-Court Advantage
Overcoming Technophobia
These Funds Are Counting on Undervalued Sectors
Our Favorite Mutual Funds
50 Most-Popular Equity ETFs
Undervalued Stocks With Wide Moats
What Price Advice?
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