Risk/Reward valuation of the Bond Market
The Bloomberg U.S. Aggregate Bond index (Formerly the Barclays Aggregate Bond Index), the widely followed benchmark measure for the broad U.S. bond market, generated a total return of 7.51% last year. That performance was primarily due to the Federal Reserve buying all manner of fixed income instruments. The Fed has promised that their monetary manipulation will continue into the foreseeable future, but some members have raised the topic of tapering the purchases.
With that, should investors expect similar returns in the coming 12 months? Alternatively, if interest rates rise, what is the magnitude of loss that an investor should expect? With interest rates hovering near decade’s low levels, we believe that now is the time for fixed income investors to understand the potential risk and reward of their bond portfolio. This paper seeks to generally quantify the current value and risk inherent in the Treasury bond and the corporate bond markets.
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.
As a valuation benchmark, I compare metrics to those witnessed in 2005, a time when the economy, inflation and Fed policy was arguably in equilibrium. At that time, the 7-year Treasury note yielded 4.43%, but 3.40% of that yield was compensation for expected inflation, as measured by the University of Michigan 12-month Inflation Expectations index. From that, the investor expected to be rewarded with 1.03% more purchasing 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 for a risk-free Treasury note. 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 0.83% and inflation expected to register 2.50% in the coming 12 months (also based upon the University of Michigan Index), an investor holding the note for one year would realize 1.77% less purchasing 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 3.50% 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 is16.75% overvalued.
Turning to the corporate bond market we employ a similar 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 investor’s demand 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 on January 15, 2021, the credit risk premium has shrunken to a less attractive 0.40%. Returning to the bond calculator, we find that an investor would most likely collect the 1.23% Yield to maturity of the Aggregate index and nothing more.
Considering the two measures of valuation, the astute investor is likely to conclude that assuming the risk of an 16.75% loss to achieve a 1.23% gain doesn’t make a lot of sense. Especially, given that the market and the economy are a long way from what one would consider equilibrium.
Additionally, we believe it’s quite possible that as the Federal Reserve begins to raise interest rates, the credit risk premium could widen. That premium has a high correlation with the stock market and given the heightened volatility witnessed in that market lately, such a widening seems plausible. To revisit the question “Can an investor expect 2021-like performance from the bond market”? Our answer is “Quite possibly, but investors should consider the downside and not be seduced by recent performance.”
References to specific investments or strategies are for illustrative purposes only and should not be relied upon as a recommendation to purchase or sell such investments or to engage in any particular strategy. Opinions expressed herein are based on current market conditions and based on certain assumptions and may change without notice. Recipients are advised not to infer or assume that any investments, companies, sectors, strategies or markets described will be profitable or that losses will not occur. Actual events are difficult to predict and are beyond our control. Actual events may be different, perhaps materially, from those assumed. This report is not to be considered an offer to sell or solicitation of an offer to buy the investments or to engage in a strategy similar to the one discussed herein. Assumptions are based on information available as of the date hereof and we assume no responsibility to update this report based on a change in underlying assumptions or market conditions. There is no assurance that the results discussed herein can be realized or that actual returns or results will not be materially different than those presented. Past performance is no guarantee of futures results.
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