It's All in the Math - Fixed Income Returns for the Decade Ahead (1 of 2)

It is becoming a more common belief that equity and bond market returns are likely to be lower than normal in the years ahead.  If proven out, this will have negative implications for the many retirement plans that have target return assumptions based off of historical norms.  Shortfalls in returns will require additional contributions - either out of corporate profits (for private plans), or out of the pockets of taxpayers (for public plans).  Expected blended return expectations remain above 7.5% for most plans.  Returns from traditional fixed income and equity markets will not reach this level and a rethinking of expectations and asset allocations will be necessary. 

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.

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.

Not So Random Thoughts

It has been a busy few months, not that the volume of postings to this blog (zero) is indicative. However, in the next few weeks, I will be able to share news regarding a new venture about which I am very excited and shortly thereafter release a white paper that I hope will cause many readers to reconsider the way they view the typical investment opportunity set.  But, until then, a lot has transpired in the global economy and I wanted to share with you some of what I think to be the most interesting and significant insights out there today.


THE RISK TRADE IS ON.  BUT FOR HOW LONG?

Plan sponsors and investors in general have become somewhat frustrated by the returns available from "low risk" investments such as cash and high grade bonds.  As a result they have progressively taken on greater amounts of risk in the quest for higher returns.  That is all well-and-good, but the question becomes whether and when they may have over reached and set themselves up for potential disappointment.

Consider:

• US Households now hold the largest percentage of their financial assets in risk assets (stocks, corporate bonds and mutual funds) since Q3 2000.  At 34.9% of total, holdings in these risk assets is just short of the 60-year high of 38.4% reached in Q1 2000 (blog).

• Spain, just a couple years ago, seemed on the verge of imploding.  This past month the Kingdom of Spain was able to issue notes that traded BELOW those of the US Government. Two years ago, they paid more than 7 percentage points more than Uncle Sam (article).  Even Greece has been able to issue bonds at a yield of 5% in spite of the fact that their finances (Debt/GDP) and employment situation are in worse shape than when the crisis began (blog).

• And even the riskiest markets are becoming more expensive.  Last year we saw investors gobble up offerings from Nigeria, Ghana, Mozambique and Zambia. The interest rate spread on Eurobonds issued by such frontier markets has fallen to below 400 basis points versus US Treasuries while the gap between JP Morgan's Emerging Market Bond Index and Frontier bond markets narrowed to a record 68 basis points this past month (article). 

In summary, spreads are narrow:

Issuers have flooded the markets:

And "safe" assets have been shunned:

Which raises the question of whether we've gone too far.  I don't believe we are there yet, but the caution lights are on and a reduction in risk is advised.  In a recent speech, Federal Reserve Governor Jeremy Stein cited the work of Harvard professors Robin Greenwood and Samuel Harrison who developed a credit-based early warning measure - simply the ratio of the volume of non-investment to investment grade issuance (rather than the more typical relative price measure, the comparison of spreads).  At prior stress points, this ratio reached extreme levels.  Though we are not quite there today, we are in the neighborhood (blog).  .  

STILL, THE SEARCH FOR RETURN CONTINUES

Traditional asset classes are getting pricey when measured against historical norms, whether we're looking at stock P/E ratios, bond yields or credit spreads.  So perhaps it's not surprising that hedge fund assets have reached new record highs as investors seek alternatives.  Hedge Fund tracking firm HFR noted that Assets Under Management at hedge funds reached new highs in each of the past seven quarters and that hedge funds now managed in excess of $2.7 trillion (article).  Yet, at the same time, hedge funds as a group posted their worst Q1 results in six years, and over the past 12 months, hedge funds were up just 8.53% compared to the S&P 500, up 19.32%.  Since the beginning of 2011, the HRF Equity Hedge Index (long/short funds) has actually lost more than 7% while the S&P is up 59% (article). Defenders of the industry will note that the word "hedge" implies they should lag in an up market because of the downside protection offered when things turn bad.  We will see, but investors should be very comfortable with the strategies employed by their managers and understand how they have performed in tough periods in the past, because the testing of the "hedge" may be forthcoming. 


WITH LITTLE HELP FROM EARNINGS

Over time, earnings drive stock prices - or so we have been led to believe.  In the short-run, this isn't necessarily the case as the value one places upon each dollar of earnings (the P/E ratio) can fluctuate based on expectations for the future or on current levels of risk tolerance (see above).  However, if earnings growth really is the longer-term fundamental link to equity performance, one might begin to get a little nervous.  From the last earnings peak (Q2 2007) through the first quarter of this year, we have seen the second weakest earnings cycle in more than 50 years.  Previous cycles have averaged 6.0% compounded annual growth as measured from peak-to-peak. Currently, we are on track for just 2.6% annualized -  and though well below the norm in terms of magnitude, in terms of duration, this cycle is just about average.

ROOKIE MISTAKES?

As interest rates hover near record lows, corporate treasurers have been quick to take advantage and lock-in the attractive funding costs.  Corporate debt levels have climbed, even as interest costs have fallen.  At the same time, the US Government has decided to issue its first-ever floating rate notes (FRN's).  Instead of locking in today's low rates, taxpayer interest costs will fluctuate in line with the market.  As rates rise, so will interest costs.  Should rates fall, costs may go down, though that benefit is limited as we are already close to the zero floor.  It seems to be a one-side trade and not one in the taxpayer interest.

Not to be outdone by the Treasury Department, the Federal Reserve has been lengthening the maturity of the Treasuries it holds in its portfolio.  The $2.3 trillion portfolio now shows bonds with a maturity of more than 10 years comprising 26% of holdings (versus 18% just four years ago).  Maturities of between five and ten years account for 37% of holdings versus 26% as recently as 2010.  Short-term notes (91 days to one year) were 23% of holdings prior to 2008.  Today they are zero.  This means, the Fed has taken on more interest rate risk just as rates trade near historic lows.

It appears the US Government (and by extension, taxpayers) have taken the opposite side of the bet from Corporate America.

THE DARK SIDE OF QE?

Supporters of the Federal Reserves' massive quantitative easing programs (aka QE1, 2 and 3), when confronted with the question of why things haven't worked out better, say "it wasn't big enough" - an argument that could be made no matter the size of the program or the outcome.

If you want to see what big does, however, just look at the Bank of Japan and their impact on the Japanese government bond market. The JGB market is larger in size than even the US Treasury market.  In spite of the smaller economy, the BoJ holds nearly the same amount of its own government debt as does the Fed.  So what can go wrong?  In reality, plenty.  The BoJ is, essentially, the Japanese bond market, having pushed all other players to the sideline.  For the first time in 13 years, the benchmark 10-year bond went untraded - not one single trade - for more than a day.  Overall trading volume is down nearly 70% from the same period last year.  When a central bank intervenes in a public market, prices are naturally distorted - in this case pushing yields lower than might be expected.  Given the lack of liquidity in the market, traders and investors worry what happens when the big buyer tries to catch his breath.  The answer is that yields can spike dramatically in a short period of time, leaving bond investors with large losses (article).  Better to sit on the sidelines or go elsewhere seems to be the result.

Meanwhile, savers are penalized while debtors reap the benefits of cheap money.  As discussed in a previous posting, "Winners and Losers (Nov 17, 2013), while the low interest rate policies have bailed out the banks, boosted the stock market and real estate, those with money on deposit have lost ground to inflation.  Richard Barrington, an analyst at Moneyrates.com, estimates that U.S. savers have lost $758 billion since the crisis began due to the erosion of purchasing power from the difference in interest earned and inflation  (article).  The McKinsey study cited in my earlier posting looked at the cost by estimating what savers could have earned had rates been in a more normal rate state relative to the level of inflation.  In either case, the costs are not insignificant.

HAVE I PAID MY FAIR SHARE YET?

And how can we let April 15th go by without commenting on taxes?  By this year's tax deadline, Americans as a group paid roughly $3 trillion in federal taxes and $1.5 trillion in state taxes, an amount greater than they will spend on the necessities of life - food, clothing and shelter (article). 

And, as the tax take has climbed, wealthier Americans continue to shoulder a larger portion of the federal tax burden.  According to the Tax Policy Center, the top 1% of earners, who take home 17% of all income, now pay 29.3% of all taxes (article). 

Many will argue that this is fair, or that the "rich" should do even more.  But just who are these 1% er's? According to a study by Thomas Hirschl of Cornell and Mark R. Rank of Washington University, 12% of the population will find themselves in the top 1 percent of the income distribution for at least one year during their career.  39% of Americans will spend at least a year in the top 5 percent and more than half will spend at least a year in the top 10%.  An astounding 73% will spend a year in the top 20 percent of the distribution. So rather than thinking of the top group as a fixed bastion of fat cats who deserve to be flayed annually, perhaps we should remember it is most people who dream the dream and often get pretty close, only to fail to stay there that are supposedly not paying their fair share (article).

But at least we're not the Europeans (yet).  The chart below from the consultancy of Ernst & Young shows the number of days of work it takes for citizens of a given country to pay their respective tax burden:

WHAT TO DO?

To those readers who agree that the topics raised about are potentially troublesome, the question of what to do next remains paramount.  With traditional asset classes historically expensive, economic growth below trend, the unknown consequences of Central Bank interventions yet to be felt and aggressive return hurdles to be met, we all have our work cut out.

I hope to offer at least one alternative in my coming white paper.  Please stay posted.