How Bad Could Bond Market Losses Get?

A few years ago Vanguard performed a study to see how the Barclays Aggregate Bond Index would be affected by an overnight 3% rise in interest rates (something that has never actually occurred). They calculated what would happen if rates suddenly rose from 2.1% to 5.1% and showed the impact going out 5 years:

screen-shot-2016-11-17-at-1-19-36-pm

You can see the immediate loss would be around 13% (they also noted that the worst 12 month loss ever in bonds was -13.9% in 1974). But because the yield on bonds would now be much higher, the expected return going forward would now be around 5.1% annually, meaning the breakeven would be just over 3 years. So not exactly a crash of epic proportions.

Source: How Bad Could Bond Market Losses Get?

Global Inflation-Linked Bonds: A Primer

So what are inflation-linked bonds? They are most typically debts issued by sovereign nations whose nominal interest rate is adjusted, either up or down, by an inflation measure.Despite the obvious allure of this kind of debt — it eliminates a risk: inflation, duh! — there are not many issuers worldwide. Total global issuance is $3 trillion. The United States, with $1.2 trillion, and the United Kingdom, at about $800 billion, are the principal movers, though there is growing issuance in France, Italy, Spain, Germany, and Brazil, among other markets.

Source: Global Inflation-Linked Bonds: A Primer

Third Quarter 2016 Asset Class Returns

Asset Class Index Performance YTD 2016
Emerging Markets MSCI EM 13.8%
REITs NAREIT Equity REIT Index 13.13%
High Yield Bonds Barclays Global HY Index 14.49%
US Bonds Barclays Aggregate 5.8%
US Large Cap S&P 500 7.84%
Commodities Bloombery Commodity Index 8.63%
Developed Intl. Markets MSCI EAFE -.85%
US Small Cap Russell 2000 11.46%

How do the Mechanics of Negative Interest Rates Work?

Do bond holders that have a negative yield  pay the issuer?

chart-interest-option1

Now let’s look at an example with negative yields. If you buy the same bond at $101, and it matures a year later at $100, then your yield is -1%. You paid more for the bond than you received back when the bond matured, and you didn’t receive any coupon payments along the way. And this same mechanic can work for a bond that pays coupons. Say there is another bond that pays a $1 coupon in one year, along with the $100 you get back in maturity proceeds, in total you get $101. If you pay $102 for that bond today, then in a year you have again earned a yield of around -1%. You paid $102 in return for total cash flows of ($100+$1) = $101.

Source:  How do negative interest rates work?

On Inflation, Prepare for the Unexpected

Inflation levels are low and expected to remain low—but that’s no excuse for not protecting against unexpected moves, according to Meketa Investment Group.The Boston-based consultant advocated for allocations to inflation-protected bonds and real assets to safeguard portfolios against sudden inflation spikes.“Holding assets that do not decline in real value during unexpected inflationary periods enhances the ability of the total portfolio to make payouts while protecting its value on the downside,” the authors wrote. “This diversification reduces the volatility of the total portfolio’s value, even though the inflation-hedging assets may demonstrate considerable volatility when viewed in isolation.”

Source: On Inflation, Prepare for the Unexpected | Chief Investment Officer

Edward Altman: The Benign Credit Cycle Is in Extra Innings

Edward Altman says the benign credit cycle is in “extra innings,” but the metaphorical relief pitchers — central bankers — are running out of gas.

 

Source: Edward Altman: The Benign Credit Cycle Is in Extra Innings

So What Is Risk Parity?

A note from Bridgewater Associates, an investment firm that oversees US$150 billion in client assets, vividly described how its founder, Ray Dalio, “laid the foundation” of risk parity while developing the All Weather investment strategy. The idea for All Weather is simple: Different economic scenarios pose risks to different asset classes throughout the business cycle. Dalio and his team identified four major risk scenarios and made sure that at least a part of the portfolio could weather each risk. So this is where the All Weather is similar to risk parity: Instead of targeting optimal risk and return in the traditional portfolio optimization setting, both strategies strive to achieve balanced risk contributions from all asset classes.

Source: Risk Parity Made Easy: Cliff’s Notes

First Quarter 2016 Asset Class Returns

Asset Class Index Performance Q1 2016
Emerging Markets MSCI EM 5.8%
REITs NAREIT Equity REIT Index 5.8%
High Yield Bonds Barclays Global HY Index 4.1%
US Bonds Barclays Aggregate 3.0%
US Large Cap S&P 500 2.0%
Commodities Bloombery Commodity Index 0.4%
Developed Intl. Markets MSCI EAFE -0.4%
US Small Cap Russell 2000 -1.5%

“Not everything that can be counted counts, and not everything that counts can be counted.”

So often in the investment business, we look for answers in quantitative models. Systemic risk is 19.2 — time to hedge! Systemic risk has fallen to 7.9 . . . Phew, we can all breathe easier now! Alas, if only it was so simple. There is a quote, often and perhaps erroneously attributed to Albert Einstein, “Not everything that can be counted counts, and not everything that counts can be counted.” Apocryphal or not, it’s true in all walks of life and certainly true in evaluating systemic risk.

Source: Systemic Risk: You’ll Know It When You See It