While Wall Street
analysts debate the next market turn, far too little effort is being put into
understanding the longer-term outcomes likely from various asset
classes. Though this is a more precise
and, arguably more important, exercise than the one they choose to pursue, it
remains a neglected area of research.
The bad news is that even under the most optimistic default and recovery
scenarios, returns from nearly every fixed income segment will barely breach 4%
in the coming decade. Investment-grade
segments will struggle to return to reach a “3-handle”. Equity returns will be better, but that’s a
relative comparison, and returns from most developed equity markets will struggle
to crack 5%, with European markets faring somewhat better.
In my previous posting, I identified a little talked about risk to corporate earnings – the substantial prop to margins provided by the Fed-created low interest rate environment. While it is important to understand that this risk exists and its magnitude, it does little to identify when the risk becomes a market issue. It is in this regard, Investors and Wall Street Analysts spend untold hours and countless dollars in their efforts to forecast short-term market returns. Yet in spite of these efforts, in nearly 30 years in this industry, I have yet to meet anyone who has been able to do this successfully and consistently – this author included. At the same time, I have seen more than a handful of practitioners who have been able to fairly accurately determine long-term returns from various fixed income and equity markets. It is ironic then that despite these long-term forecasts being both more accurate and ultimately more important to investors such as endowments, foundations and corporate pension committees, greater efforts continue to be devoted to analysis based on short term market twists and turns.
This posting and the next are for those willing to look
beyond the coming quarter. Using a model
I originally developed in the late 1990’s, I provide what I believe to be
reasonably accurate return projections for fixed income and global equity
market over the coming decade, along with the methodology for doing so. Since its introduction, this approach has quite
accurately called market outcomes.
Let’s start with fixed income markets. As you know, a bond is a fairly simple
instrument with returns accruing to just four factors: the price paid, the coupon
payments received, the reinvestment of those coupons and the ultimate return of
principal. Taking each in turn, we know the
price paid. We also know the coupon
payment as it is contractual in nature.
The reinvestment return of these coupons is unknown; however, as I will
demonstrate below, even an immediate, radical move in interest rates will not dramatically
change the overall return of a bond over its lifetime. Finally, while return of principal to a
single bond may be uncertain, when looking at the broader market of bonds of
similar ratings, historical experience can provide a reasonable guide as to
default and recovery rates. Putting
these together, estimating long-term bond returns is a very straight forward
process.
Let’s use ten-year US Treasury notes as an example. At July 21st, you could buy a
ten-year government security with a maturity of May 15, 2023 for a price of $93.64. That note will pay a semi-annual coupon at an
annual rate of 1.75%. At maturity, an
investor will receive $100 and along the way, twice yearly coupon payments of $0.875
(per $100 value). While we do not know
the rate at which those coupons will be reinvested, even if we assume rates
rise by 500 basis points before the first coupon payment is received (to 7.48% across
all maturities), the total annualized return from this note will rise only to
2.96% over the ten year period. Conversely,
if rates fell to zero and an investor received no return at all on the coupons,
the ten year total annualized return on this note falls only to 2.29%. Thus, assuming no default, one can not
realistically expect anything other than a return of between 2.29% and 2.96% from
buying a ten-year US government note today.
Another way of looking at this is, assuming no risk of default, the best
approximation of the long-term return on a bond is probably just its current
yield (on the UST, currently 2.48%).
Looking at other developed government bond markets (G-7 plus
Australia and Spain), we note the 10-year yields between 0.78% (Japan) and
4.60% (Spain). Assuming no risk of
default, these again are the best estimate for ten-year local currency
returns.
Source:
Bloomberg
Of course, given the recent experience of Greece and
on-going concern across the Eurozone, zero chance of default might not be the
best assumption. If one wanted to insure
themselves against default risk, we can look to the Credit Default Swap market
to gauge the costs. Higher yielding
markets such as Spain and Italy currently have annual “insurance” costs of
3.06% and 3.08%, respectively. Perceived
“safe” markets like the US and Germany have lower insurance costs of 0.41% and
0.65%, respectively. Calculating the
“net” return with insurance, we see an expectation for ten-year returns between
2.90% (Australia) at the high end and -0.46% (Japan) at the low end.
Government markets are not the only fixed income
game in town. Lower rated corporate
credits, mortgage securities and the like broaden an investor’s opportunity
set. Still, like the sovereign bond
markets, the current yield on these instruments, less an assumed default and
recovery rate, makes for the best long-term expectations of their likely
returns. However, since default and
recovery rates are uncertain, it is best to examine these markets using
scenario analysis, tweaking each of these two variables.
While there are many segments within the broader fixed
income universe, for the purposes of this posting, I have chosen to project
returns for US High Yield, European High Yield, Emerging Market Foreign-Pay Sovereign
and US Investment Grade segments – all fairly liquid markets. Current Yields and Spreads are shown below.
US
High Yield
|
Euro
High Yield
|
EM
Sovereign
|
US
Inv Grade
|
|
Current Spread
|
4.45
|
5.28
|
5.06
|
2.05
|
Historic Spread
|
5.24
|
6.42
|
4.30
|
1.95
|
Current Yield
|
6.01
|
5.85
|
7.66
|
3.87
|
Source: BofA
Merrill Lynch, Brett Gallagher Calculations
Once again, assuming no default, Current Yield is our best
guess at the long-term return from the various fixed income segments. However, as there is some realistic level of
default expected in each of these riskier pools, building a sensitivity
analysis around the historic default level and recovery rates makes sense and
is detailed in the tables below.
For this analysis, I have turned to data gathered by Moody’s
Investors Service which examines cumulative 10-year default percentages
beginning annually in 1970. I then
convert this cumulative figure into an annual one and plug the median default experience
(noted by red font), the worst 10-year default experience, the
best 10-year default experience and the 25th and 75th
percentile default experience. Because
of the longer history of the US data, I use that experience for other speculative
markets as well (note: using a common data set with an inception date of 1983, European
High Yield and EM Sovereign Debt actually have lower default rates than the US
Universe over the common period – in the case of sovereign debt, about half
that of US Corporates, though the range of outcomes is also wider).
Default rates are calculated using Moody’s study of Cumulative
10-Year default rates over the period 1970 to 2010. Following the cumulative default outcomes, in
parenthesis, I show the annual equivalent default that results in the
cumulative figure and that is used in the sensitivity tables below.
Baa-Rated
|
US,
Euro, EM Sovereign
|
|
Worst Case
|
10.34% (1.10%)
|
43.60% (5.65%)
|
25th Percentile
|
5.87% (0.61%)
|
38.53% (4.80%)
|
Median
|
4.74% (0.50%)
|
33.15% (4.00%)
|
75th Percentile
|
3.76% (0.38%)
|
19.88% (2.20%)
|
Best Case
|
1.16% (0.11%)
|
8.23% (0.85%)
|
Source: Moody’s,
Brett Gallagher
* Users
familiar with Moody’s data may note that my model default assumptions, when converted to annual rates, are lower
than the annual average default rates over the period. As certain outsized years have the effect of
distorting the overall calculation of “average” and, as we are looking at a
10-year horizon, I feel the cumulative data, converted to an annualized figure,
is more relevant.
Using a wide range of default and recovery assumptions, we
are able to construct a narrow range of likely outcomes for nearly any fixed
income segment we desire. While the
returns due to risk assets appear relatively attractive when compared with developed
sovereign markets, the range of returns are far below historic experience and
most investors assumed return assumptions.
US High Yield Debt –
Current Yield 6.01%, Median 33.1% 10-year Cumulative Default
| Annualized Default Rates | ||||||
| Recovery Rate | 0.85% | 2.20% | 4.00% | 4.80% | 5.65% | |
| 20.0% | 5.31% | 4.43% | 3.30% | 2.83% | 2.34% | |
| 25.0% | 5.34% | 4.50% | 3.45% | 3.00% | 2.54% | |
| 30.0% | 5.37% | 4.58% | 3.59% | 3.18% | 2.75% | |
| 35.0% | 5.40% | 4.66% | 3.74% | 3.35% | 2.95% | |
| 40.0% | 5.43% | 4.73% | 3.88% | 3.52% | 3.15% | |
| 45.0% | 5.46% | 4.81% | 4.01% | 3.68% | 3.35% | |
| 50.0% | 5.49% | 4.89% | 4.15% | 3.85% | 3.54% | |
European High Yield Debt – Current Yield 5.85%, Median 33.1% 10-year Cumulative Default
| Annualized Default Rates | ||||||
| Recovery Rate | 0.85% | 2.20% | 4.00% | 4.80% | 5.65% | |
| 20.0% | 5.16% | 4.27% | 3.14% | 2.67% | 2.17% | |
| 25.0% | 5.19% | 4.35% | 3.29% | 2.84% | 2.38% | |
| 30.0% | 5.22% | 4.43% | 3.44% | 3.02% | 2.59% | |
| 35.0% | 5.25% | 4.50% | 3.58% | 3.19% | 2.79% | |
| 40.0% | 5.28% | 4.58% | 3.72% | 3.36% | 2.99% | |
| 45.0% | 5.31% | 4.66% | 3.86% | 3.53% | 3.19% | |
| 50.0% | 5.34% | 4.73% | 4.00% | 3.69% | 3.39% | |
US Investment Grade (BBB) – Current Yield 3.87%, Median 4.7% 10-year Cumulative Default
| Annualized Default Rates | ||||||
| Recovery Rate | 0.11% | 0.38% | 0.50% | 0.61% | 1.10% | |
| 20.0% | 3.76% | 3.57% | 3.48% | 3.40% | 3.06% | |
| 25.0% | 3.77% | 3.58% | 3.50% | 3.43% | 3.10% | |
| 30.0% | 3.77% | 3.60% | 3.52% | 3.45% | 3.14% | |
| 35.0% | 3.77% | 3.61% | 3.54% | 3.47% | 3.18% | |
| 40.0% | 3.78% | 3.62% | 3.56% | 3.50% | 3.23% | |
| 45.0% | 3.78% | 3.64% | 3.58% | 3.52% | 3.27% | |
| 50.0% | 3.79% | 3.65% | 3.60% | 3.54% | 3.31% | |
EM Sovereign (USD Pay) – Current Yield 7.66%, Median 33.1% 10-year Cumulative Default
| Annualized Default Rates | ||||||
| Recovery Rate | 0.85% | 2.20% | 4.00% | 4.80% | 5.65% | |
| 20.0% | 6.85% | 6.00% | 4.92% | 4.46% | 3.98% | |
| 25.0% | 6.88% | 6.07% | 5.05% | 4.62% | 4.18% | |
| 30.0% | 6.91% | 6.14% | 5.19% | 4.78% | 4.37% | |
| 35.0% | 6.93% | 6.21% | 5.32% | 4.94% | 4.55% | |
| 40.0% | 6.96% | 6.29% | 5.45% | 5.10% | 4.74% | |
| 45.0% | 6.99% | 6.36% | 5.57% | 5.25% | 4.92% | |
| 50.0% | 7.02% | 6.43% | 5.70% | 5.40% | 5.10% | |
In my next post, I turn to global equity markets.
