Using models I originally developed in the late 1990’s, we can arrive at accurate return projections for both fixed income and global equity market over the coming decade.
Starting with fixed income markets. A bond is a fairly straight forward 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 payments as they are contractual in nature. The reinvestment return of these coupons is unknown; however, as I will demonstrate, 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.
AN EXAMPLE
At July 30th, you could buy a ten-year US government note with a maturity of May 15, 2024 for a price of $99.49. That note will pay a semi-annual coupon at an annual rate of 2.50%. At maturity, an investor will receive $100 and along the way, twice yearly coupon payments of $1.25 (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 7.56% across all maturities), the total annualized return from this note will rise only to 2.85% 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 expect anything other than a return of between 2.29% and 2.85% 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 2.56%). Of course, the road to that compounded annual return need not be smooth. Outsized returns or losses in a near-year, will cause out-year returns in the other direction as the result is mathematically determined.
DEVELOPED MARKET SOVEREIGN DEBT
Looking at other developed government bond markets (G-7 plus Australia and Spain), we note 10-year yields between 0.53% (Japan) and 3.43% (Australia). Assuming no risk of default, these again are the best estimate for annualized local currency returns over the coming decade.
Source: Bloomberg
Of course, given the recent experience of certain governments (Argentina, Greece), 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 of protection. Higher yielding markets such as Spain and Italy currently have annual “insurance” costs of 1.15% and 1.56%, respectively. Perceived “safe” markets like the US and Germany have lower insurance costs of 0.25% and 0.42%, respectively. Calculating the “net” return with insurance, we see a lower expectation for ten-year returns of between 2.87% (Australia) at the high end and -0.26% (Japan) at the low end. Needless to say, developed market sovereign returns of 1% - 3% are not going to get plans to their return targets.
Source: Bloomberg
INVESTMENT GRADE, HIGH YIELD AND EMERGING MARKETS
Of course, 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 and we have seen dramatic evidence of plans reaching for yield over the past couple of years. 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.
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 USD/EUR-Pay Sovereign and US Investment Grade segments – all fairly liquid markets. Current Yields and Spreads (versus governments) are shown below.
US High Yield
|
Euro High Yield
|
EM Sovereign
|
US Inv Grade
| |
Current Spread
|
3.75
|
4.49
|
5.05
|
1.45
|
Historic Spread (Median)
|
5.34
|
5.89
|
4.78
|
1.97
|
Current YTM
|
5.90
|
4.49
|
6.84
|
4.65
|
Source: BofA Merrill Lynch, Brett Gallagher Calculations
Once again, assuming no default, Current Yield to Maturity is our best guess at the long-term return from the various fixed income segments (between 4.5% and 7.0% in this example). 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 (detailed in the tables below).
For reasonable default and recovery assumptions, I turned to data gathered by Moody’s Investors Service which has compiled cumulative 10-year default percentages across a number of markets and ratings classes for the 10-year periods ending 1970 - 2013 and also used their observed historical recovery percentages.
I have converted the cumulative default figures into annual ones (shown in parenthesis below). For the sensitivity analysis, I use the Worst, 25th Percentile, Median, 75th Percentile and Best Case historical experiences - though I would expect the 25th to 75th percentile range to capture the most likely outcomes. 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 – thus my assumptions may be slightly conservative). For recovery rates, the sovereign experience has been better than corporates by about 10 percentage points and is also reflected in the sensitivities.
I have converted the cumulative default figures into annual ones (shown in parenthesis below). For the sensitivity analysis, I use the Worst, 25th Percentile, Median, 75th Percentile and Best Case historical experiences - though I would expect the 25th to 75th percentile range to capture the most likely outcomes. 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 – thus my assumptions may be slightly conservative). For recovery rates, the sovereign experience has been better than corporates by about 10 percentage points and is also reflected in the sensitivities.
10-Year Cumulative (Annual Equivalent) Default Rates (1970 - 2013)
Investment Grade
|
US HY, Euro HY, EM Sovereign
| |
Worst Case
|
10.33% (0.97%)
|
45.88% (3.85%)
|
25th Percentile
|
5.91% (0.58%)
|
38.93% (3.34%)
|
Median
|
4.89% (0.48%)
|
32.33% (2.84%)
|
75th Percentile
|
3.63% (0.36%)
|
18.80% (1.74%)
|
Best Case
|
1.26% (0.13%)
|
0.37% (0.04%)
|
Source: Moody’s, Brett Gallagher
Using a plausible range of default and recovery assumptions, we are now 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 – Yield to Maturity 5.90%, Median 10-year Cumulative Default 32.3%
| Annualized Default Rates | ||||||
| Recovery Rate | 4.31% | 0.04% | 1.74% | 2.84% | 3.34% | 3.85% |
| 30.0% | 5.76% | 4.74% | 4.12% | 3.84% | 3.57% | |
| 35.0% | 5.76% | 4.80% | 4.22% | 3.96% | 3.70% | |
| 37.5% | 5.76% | 4.83% | 4.27% | 4.02% | 3.77% | |
| 40.0% | 5.76% | 4.86% | 4.31% | 4.08% | 3.84% | |
| 42.5% | 5.76% | 4.89% | 4.36% | 4.13% | 3.90% | |
| 45.0% | 5.76% | 4.92% | 4.41% | 4.19% | 3.97% | |
| 50.0% | 5.76% | 4.98% | 4.51% | 4.31% | 4.10% |
European High Yield Debt – Current Yield 4.49%, Median 10-year Cumulative Default 32.3%
| Annualized Default Rates | ||||||
| Recovery Rate | 2.93% | 0.04% | 1.74% | 2.84% | 3.34% | 3.85% |
| 30.0% | 4.42% | 3.36% | 2.72% | 2.44% | 2.15% | |
| 35.0% | 4.42% | 3.43% | 2.83% | 2.56% | 2.30% | |
| 37.5% | 4.42% | 3.46% | 2.88% | 2.63% | 2.37% | |
| 40.0% | 4.42% | 3.49% | 2.93% | 2.69% | 2.44% | |
| 42.5% | 4.42% | 3.53% | 2.99% | 2.75% | 2.52% | |
| 45.0% | 4.42% | 3.56% | 3.04% | 2.81% | 2.59% | |
| 50.0% | 4.42% | 3.62% | 3.14% | 2.93% | 2.73% |
US Investment Grade (Baa) – Current Yield 4.65%, Median 10-year Cumulative Default 4.89%
| Annualized Default Rates | ||||||
| Recovery Rate | 3.09% | 0.04% | 0.19% | 0.23% | 0.34% | 0.52% |
| 30.0% | 4.57% | 4.47% | 4.45% | 4.38% | 4.27% | |
| 35.0% | 4.57% | 4.48% | 4.46% | 4.39% | 4.29% | |
| 37.5% | 4.57% | 4.49% | 4.46% | 4.40% | 4.30% | |
| 40.0% | 4.57% | 4.49% | 4.47% | 4.40% | 4.31% | |
| 42.5% | 4.57% | 4.49% | 4.47% | 4.41% | 4.31% | |
| 45.0% | 4.57% | 4.50% | 4.47% | 4.42% | 4.32% | |
| 50.0% | 4.58% | 4.50% | 4.48% | 4.43% | 4.34% |
EM Sovereign (USD/EUR Pay) – Current Yield 6.84%, Median 10-year Cumulative Default 32.3%
| Annualized Default Rates | ||||||
| Recovery Rate | 5.21% | 0.04% | 1.74% | 2.84% | 3.34% | 3.85% |
| 40.0% | 6.64% | 5.75% | 5.21% | 4.98% | 4.74% | |
| 45.0% | 6.64% | 5.81% | 5.31% | 5.09% | 4.87% | |
| 47.5% | 6.64% | 5.84% | 5.35% | 5.14% | 4.93% | |
| 50.0% | 6.64% | 5.87% | 5.40% | 5.20% | 5.00% | |
| 52.5% | 6.64% | 5.89% | 5.45% | 5.25% | 5.06% | |
| 55.0% | 6.64% | 5.92% | 5.49% | 5.31% | 5.12% | |
| 60.0% | 6.64% | 5.98% | 5.59% | 5.42% | 5.25% |
In my next post, I turn to global equity markets.
