Interest rate volatility is back
The last month has seen a jump in interest rates, followed by a similar decline in rates. For most of the second half of 2011 and the first couple of months of 2012, rates along the yield curve were remarkably stable. And why not? The FOMC had as much as guaranteed that rates would remain at “exceedingly low levels” for “an extended period” and they announced their intention to keep the funds rate near 0.00% until late 2014. Investors got complacent about interest rate risk.
Then came March 14, 2012. The statement on interest rates that was issued following the March 13 FOMC meeting put a more positive spin on the Fed’s economic outlook. Yields jumped +30 basis points along the yield curve within a few days. Various members of the FOMC began making speeches to the effect that accommodation was over and Fed tightening was going to happen much sooner than had been discussed.
The European bond crisis had been kicked down the road by the massive loan program introduced by the ECB at the end of 2011. Spanish and Italian bond yields were declining sharply.
The rise in interest rates put a dent in the unrealized gains that have accumulated in credit union bond portfolios.
Fast forward to April 13, 2012. The latest Nonfarm Payroll report was a disappointing 120k jobs. Initial Jobless Claims jumped to 380k, well above recent weekly averages. Spain roared back into the headlines as their crisis has already been resurrected.
Interest rates have now moved back to where they were in mid-February, before the rate hiccup took place.
So now what? Time to assess your attitude toward the market
Interest rate volatility has returned, at least for now. It would be a good time to reflect on how you felt during the stressful days when rates jumped. Were you nervous about the eroding value of your portfolio? Were you happy to use the temporary move to higher rates to add investments at better levels? Is your current rate outlook more in tune with the rise in rates or more compatible with the subsequent rate decline?
How you answer these questions will help determine what to do now.
What if you think rates are about to rise for an extended period?
If you became concerned about a sustained move to higher rates, then you should be thinking about orienting your portfolio to be more rate sensitive, meaning taking on floating rate securities or shorter-dated bullets. A barbell strategy can also work here where you balance these shorter term investments with bonds that have durations toward the longer end of your portfolio constraints. Barbell strategies tend to work better in a rising rate environment. Once the Fed starts to tighten, the curve will flatten as short rates go up more than longer rates. Step up agency callables might also be blended into this mix since at least you get some coupon appreciation to match the higher rates in the market.
What happens if rates return to the trading range?
If you still feel that rates will be subdued for an extended period, then a more laddered strategy would be appropriate. Ladders work best in a flat to declining rate environment as you spread your reinvestment risk over a longer horizon. In this scenario, you should be favoring better lockout-protected callables and MBS with more stable cash flows.
When is selling bonds not trading?
The last point to consider is the notion of outright selling of bonds in your portfolio. As a general rule, credit unions favor interest income over capital gains. When a bond has unrealized gains in its valuation due to declining interest rates, most credit unions would rather keep clipping the coupon than booking the gain only to reinvest the proceeds of the sale into a lower-yielding current coupon.
Member boards tend to think of selling as trading. I would certainly not advocate taking on a trading mentality. If that could be done consistently, we would all be sipping Pina Coladas on a sunny beach. I am only suggesting that you take a measure of your anxiety when rates were heading higher. Even if the Fed stands by its pledge to keep rates low for an extended period, we all know that rates will go up sometime. They won’t stay this low forever.
You might consider setting some benchmark levels as triggers to do some portfolio selling. Set a goal that you will reduce your portfolio by a certain percentage if the 5-year note goes above 1.25%, as an example. If your investment team agrees on this in advance, it will make it much easier to pull the trigger when the time comes.
Director of Investment Sales
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