Despite the price weakness observed during the month, we continue to believe that U.S. Treasury interest rates remain artificially low and that corporate and municipal debt offers an attractive investment opportunity. To detail that thesis, we’ve prepared the following valuation discussion.
In its simplest form, valuation is the expected purchasing power (also known as the real rate of return) of a dollar invested in a bond at the end of a holding period, given the current interest rate and anticipated rate of inflation. The starting point for this exercise is the U.S. Treasury note, also known as the “risk-free” rate. Note that “risk-free” refers to credit-worthiness, not interest rate sensitivity. As Figure 1 illustrates, the risk-free Treasury rate can be described as a combination of the inflation rate and the real rate. In 2005, a 7-year Treasury note yielded 4.43%, but 3.40% of that yield was compensation for expected inflation, as measured by the Consumer Price Index. From that, the investor expected to be rewarded with 1.03% more buying power at the end of the one year holding period. The “rule of thumb” among bond investors is that a real rate of 1.0% is approximately fair value. At the end of 2005, one could conclude that the 7-year note in question was fairly valued. The circumstances today are much less favorable. With the 7-year note yielding 1.38% and inflation registering 3.0%, an investor holding the note for one year would realize 1.62% less buying power at the end the holding period. Using the 1% real return “rule of thumb,” the current 7-year note would need to rise to 4.0% to be considered fairly valued. Inputting that interest rate differential into a bond calculator delivers the astonishing conclusion that the price of the 7-year note is 15% overvalued.
Turning to the corporate bond market we employ a similar relative valuation technique to determine fair value. In this exercise we use the Barclays Capital U.S. Credit Index as a proxy for the corporate bond market. The index has interest rate sensitivity similar to the 7-year Treasury note. To assess value, we subtract the yield-to-maturity of the 7-year Treasury note just discussed from the yield-to-maturity of the index. The difference is defined as the credit risk premium, or the incremental return the investor expects for assuming credit risk over and above the risk-free Treasury note. In 2005, subtracting the 4.43% risk-free rate from the 5.30% yield-to-maturity of the index indicated that the credit risk premium was 0.87%. Again, using rule of thumb, fixed income investors would consider a risk premium of 0.87% to be a close approximation of fair value. Refocusing on the yield-to-maturity of the index at the end of February 2012, the credit risk premium stood at a significantly more attractive 1.68%. Returning to the bond calculator, we find that an investor would enjoy approximately a 5.5% appreciation in the price of the portfolio if that spread were to narrow from the current 1.68% to 0.87%.
Considering the two measures of valuation, an investor could conclude that assuming the risk of a 15% loss to achieve a 5.5% gain doesn’t make a lot of sense. After all is said and done, the outcome would result in an 8.5% loss. However, to offset the interest rate risk, we have positioned short interest rate hedges through the futures and options market. In doing so, we are attempting to profit from the relatively attractively priced corporate and municipal markets while neutralizing the downside risk inherent in U.S. Treasury notes.