Introduction
This research offering deals mainly with interest rates. This said, there is tangential mention of stocks. It is very difficult to separate the two markets completely, particularly in the current environment. More on this later.
Because of the stock market's recent better behavior, readers may wonder if anything in my thinking in this area has changed. It has not! So far, I view the market's recent up-tick as the technically driven rebound I've been expecting and have discussed in recent material.
From a longer-term perspective, in early 2000, I not only thought the equity market had entered what would be a vicious bear phase, I also believed it would be something secular in duration. And what did/does that mean? In past work, I've examined in some detail the 1965 through 1982 experience, opining the possibility the current episode could wind up resembling it. I have not changed my mind! The rally from the July/October 2002 lows through this year's highs was wonderful (and predictable), but I think the months ahead will go on to show it was a cyclical bull inside a secular bear.
Onward
I spent many of my 37 years in the financial business as a money manager. I managed both stock and bond portfolios, in that order -- first equity, then debt. If I could do it over and had a choice, I would surely do it in reverse. There simply is no question, at least in my mind, that a solid understanding of interest rates and the bond market makes one a far better stock manager. And you can witness this in the present environment in some important ways.
Something clearly raining on the stock bulls' parade this year to date has been the "sharp" rise in open-market interest rates across the Treasury yield curve. I've emphasized "sharp" for a reason I'll return to momentarily.
In assessing how much rain has metaphorically fallen on the parade, it is important to view where the stock market stands at present, versus what the expectations were not too long ago for where it was likely to stand. As this year was kicking off, the vast majority of strategists, analysts, etc. appearing incessantly on CNBC and other similar venues in the regular propaganda loop were sporting 2004 stock-market forecasts that ranged from highly constructive to wildly so! Thus, to be nearing the end of the year's fifth month in the red to breakeven, depending on what market proxy at which you are looking, represents a huge divergence from expectations.
And what are the culprits in the process? In big-picture terms, I would identify three possessing a good deal of synergy. They are: Iraq, energy prices, and open-market interest rates.
To put the current situation in better perspective, try to remember back about a year ago. At the May 2003 meeting of the Federal Open Market Committee, Greenspan and associates dropped the deflation bomb. I was convinced then, I'm more convinced now, that this was a ruse. Greenspan wanted another rate cut he simply could not have at the time, so in essence, the Fed got it a different way. By hinting at the dreaded "D" word, open-market interest rates went into a tailspin, albeit one that would not last too long.
However, the sharp decline in rates did last long enough to trigger a massive mortgage refi binge, which was just great with Mr. G. And helping the process along in a major way were all the hedge funds -- many if not most with orientations that were equity driven -- that came for the first time to play in a new sandbox -- the bond market!
Well, as the saying goes, the Lord giveth, the Lord taketh away! The mania to buy long-dated, fixed-rate obligations unleashed one helluva rally, but one that vanished quickly and with a vengeance, leaving some deep wounds to be licked by the stock-turned-bond crowd. After all, many of the participants were leveraged players, who watched their leveraged gains turn into leveraged losses.
What the episode did accomplish, at least so far, was to put a price top on the secular bull market in bonds. Last June 13th, a Friday to boot, marked the trough in yields triggered by the Greenspan bacchanal. Table 1 in the appendix at the end of the text breaks out where Treasury yields stood on that date, as well as what has happened to them since. It's not a pretty picture. The following table breaks out just the year-to-date performance.
But It's Only 30 or 40 Basis Points!
Two things have transpired recently to which I have reacted in a manner similar to a bull confronted by a red cape. One of these is an article I received earlier this week, written by a friend in the money-management business. Let's just say I "vociferously" (euphemism for "violently") disagree with most of its thesis.
The other item is something that gets rolled out by stock bulls whenever interest rates are going up or are likely to. This is a purposeful minimization of what a 30 or 40 basis-point rise in yields really means. Much of this minimization comes from sheer ignorance -- something I hope this article will help redress.
But some of the minimization also comes from Wall Street's efforts to always put the best spin possible on items that might adversely affect the stock market. Therefore, when investors assess matters that could be of more than a modicum of importance, they should keep in mind that as of the end of last year, the Fed estimated that there was $22.4 trillion of domestic nonfinancial-sector debt in existence. I think this figure strongly suggests that even a few basis points here or there is of some interest.
As the earlier table indicated, the yield on the on-the-run long Treasury bond is up 30 basis points this year to date, and this is after a decent price rally/yield decline, over the last week or so. At the recent high yield, the Treasury 5.375s of 2/15/31 stood at 5.55%, versus yesterday's 5.37%. (As an aside, the Treasury's "30-year" bond is really a "27-year" bond, since the Treasury has not auctioned a current-coupon 30-year issue since the 5.375s were issued about three years ago.)
So if you listen to most of the Wall Street cheerleaders, this mere 30 basis points was no big deal. However, if you bought the 5.375s of 2031 at the end of last year and computed your return as of yesterday's close, you might feel differently.
Between 12/31/03 and yesterday, the T-Bond holding earned interest income equaling 2.10% (non-annualized). This is not bad at all, considering that a 90-day T-Bill over the same period had a non-annualized return of only 0.39%. But ... there's more to the story. For the year to date through yesterday, the Treasury 5.375s of 2031 lost 4.10% of their principal value. Netting this against the positive income return left an investor with a non-annualized, negative return of 2.00%. Therefore, the T-Bill's paltry +0.39% whipped the bond's total return of -2.00% in a rather major way!
Now back to the other item to which I referred earlier, the piece written by my friend in the money-management business. Here's an excerpt:
"Just what is this 'total return' thing that fixed income investment managers like to talk about, and that Wall Street uses as the performance hoop that all investment managers have to jump through? Why is it mostly just smoke and mirrors? ... Applied to fixed income investment portfolios, it is useless nonsense designed to confuse and to annoy investors ... As long as the financial community remains mesmerized with their total return statistical shell game, investors will be the losers."
As I quipped earlier, "I 'vociferously' (euphemism for 'violently') disagree." I believe my above rundown on owning the Treasury 5.375s over the last five months illustrates why!
My investment-manager friend would likely counter with the argument that if you did not sell the long T-Bond at a loss, you didn't really have a loss, but you did have the fat 2.10% cash flow. Not so fast ... what about the opportunity cost? This is something a lot of people disregard but should not. A simple current-yield comparison helps illustrate what I mean.
The Treasury 5.375s of 2031 finished last year at a price of 1,044.06, corresponding to a current yield of 5.15%. At yesterday's close, the issue's price of 1,001.25 equaled a current yield of a larger 5.37%. After you run all the math you must run, the investor paying 1,001.25 will have received more cash flow or "spending money" through maturity than the investor paying 1,044.06. And the investor in at the lower price will realize less loss of principal at maturity, too, since at maturity, the US Treasury will pay both investors only $1,000 per bond owned, no matter what the investors paid in the open market for the obligation.
The moral of this story is that to disregard total return is not a wise thing to do!
But the math works in both directions. A decline in interest rates from the original purchase price/yield will produce a capital gain, at least on paper. Remember, though, that since almost all obligations mature at par or at $1,000 per bond held, paper gains disappear as the obligation moves closer to its maturity date. (For simplicity, I am not taking into account in this article features like call and refunding prices and dates, which are subjects for another time.)
In a graphical format, here is what happens to total return over a one-year holding period of a bond with a 5.375% coupon and a 27-year maturity that is purchased at a market yield of 5.375% (a price of $1,000). I've used these parameters to mirror the Treasury's "on-the-run" long bond.
The data underlying the above graph are found in Table 2 in the appendix, but what it amounts to is an increase in open-market yield of slightly more than only 40 basis points is sufficient for the loss of principal to wipe out an entire year's worth of income. On the other hand, were the yield to decline by about 48 basis points over the one year, the total return would rise to a very handsome 12.34%, of which almost 7% would be the result of price appreciation.
Because of the math governing interest rates and the bond market, price change becomes larger with a given change in interest rates as you move farther out on the yield curve. These changes are magnified even more at different coupon levels, and in the case of zero-coupon obligations. To illustrate this phenomenon, following is a graphical portrayal of what happens to total return over a one-year holding period of an issue carrying a 4.750% coupon with a 10-year maturity, purchased at a market yield of 4.750% (a price of $1,000). I've used these parameters to mirror the Treasury's recently auctioned 10-year note issue.
The data underlying the above graph are found in Table 3 in the appendix, but the bottom line here is that it takes an increase in open-market yield of almost 68 basis points for the loss of principal to wipe out an entire year's worth of income. On the other side of the ledger, were the yield to decline by about 45 basis points over the one year, the total return would rise to 8.09%, of which almost about 3.34% would be the result of price appreciation.
A Somewhat More Horrific Look at What
Has Happened to Long-Term Interest Rates
My earlier example of why it is not advisable to disregard total return involved the 30 basis-point increase in yield on the Treasury 5.375s of 2/15/31 between the end of last year and yesterday. But the following "real-life" example is even more compelling.
As mentioned earlier, the to-date trough in yields in the current interest-rate cycle took place last June 13th. At the time, the Treasury 5.375s of 2031 were yielding 4.17%. From then through yesterday's close of 5.37%, a rise in open-market yield of a whopping 120 basis points, this issue produced a rather horrifying negative total return exceeding 12%! In turn, this was the result of an income return of about 4.3%, offset by a loss in principal value of more than 16.4%.
If you are a money manager who bought the issue at a 4.17% yield basis and can get away in client meeting without showing the current market value of your holdings, I guess you are okay. When I managed fixed-income portfolios, I was never fortunate to have clients nearly this gullible!
