Fixed Income  (posted 27 Feb 99)

Fixed income securities or bonds are generally thought of as safe rather boring investments, lacking the risks associated with equities. After all, no one seems to worry about the US government defaulting on its debt and US treasuries make up a significant proportion of the bond market. In practice, though, it is possible to lose vast amounts of money by getting the bond markets wrong. Because bonds appear to have a more definable risk profile than equities, leverage tends to be more easily obtainable. And high confidence in understanding fixed income relationships may lead to excessive leverage and unexpected outcomes, as the case of Long Term Capital Management (LTCM) in the late summer of 1998 vividly illustrates.

Bonds are debt instruments, securities sold by governments, companies and banks in order to raise capital. They normally carry a fixed rate of interest, known as the coupon (usually paid every six months), have a fixed redemption value (the par value) and are repaid after a fixed period (the maturity). Some - deep discount and zero coupon bonds - carry little or no interest, instead rewarding the buyer with a substantial discount from their redemption value and hence, the prospect of a sizable capital gain.

As Michael Lewis explains in Liar's Poker, his entertaining account of life among Salomon's bond traders in the 1980s, the one thing you need to know about bonds is the relationship between their prices and interest rates. In short, as one goes up, the other goes down. This is because the fixed income paid by a bond - which when calculated as a percentage of its market price is its current yield - is equivalent to the rate of interest. If rates go up, the relative attractiveness of newly issued bonds over existing bonds increases. And since coupons are fixed, for yields to be comparable to those on new bonds, the price of existing bonds must fall.

In most developed countries outside the United States, government bonds issued in the domestic market have traditionally dominated fixed income investors' portfolios. But with the opening of markets around the world, the range of choices has increased enormously in recent years. There are now markets not only in the government bonds of developing and transition countries (see EMERGING MARKETS) but also for numerous other debt instruments: corporate bonds, junk bonds, stripped bonds, mortgage-backed securities, convertibles, and so on. In the United States, the treasury bond market is now significantly smaller than the mortgage and corporate bond markets.

Credit quality has become a key issue. For example, emerging market and corporate bonds generally carry a risk premium over US government bonds, with higher yields to reflect the more variable creditworthiness of their issuers and the greater risk of default. Periodically, bonds of an entire category - sovereign debt, real estate, junk - become nearly worthless. Under these conditions, there is a preference for liquidity and quality, making refinancing difficult or impossible for less than top quality issuers.

Interest rates and credit risks are crucial considerations in fixed income investing but perhaps most important of all is the expected future path of inflation. Inflation is bad for bonds, eroding their value as prices and yields, unless index-linked, fail to keep pace with rising prices. What is more, higher inflation or the prospect of higher inflation is usually associated with higher interest rates, as policy-makers tighten monetary conditions in order to try to contain inflation or protect a weakening currency (see FOREIGN EXCHANGE and INTERNATIONAL MONEY). This makes cash more attractive, pushing down bond returns.

The yield curve is a means of comparing rates on bonds of different maturities, as well as an indication of the tightness of monetary conditions. Longer term yields are usually higher because of the greater degree of time and inflation risk. They are a good indicator of expected trends in the rate of interest and the rate of inflation. When short-term rates are higher, there is an inverted yield curve.

It is vital for active fixed income investors to look for changes in expectations about the future rates of interest and inflation. Key indicators of these are the strength of the economy and the framework of fiscal and monetary policy (see ECONOMIC FORECASTING and POLITICS AND INVESTING). Bond markets tend to like signs of economic weakness since strong growth might trigger inflation. They also like fiscal policies that dampen the economy, squeezing out inflation.

Indeed, bond traders have become increasingly effective in preventing governments from introducing policies that may reignite inflation, hence driving interest rates higher and bond prices down. Their actual or implied threat to flee the markets in response to such policies has led to them being called 'vigilantes', and to presidential adviser James Carville's famous remark, 'I used to think that if there was reincarnation, I wanted to come back as the president or the pope. But now I want to be the bond market: you can intimidate everybody.'

Steven Mintz uses a good analogy to describe the way to approach the bond markets in his book The Art of Investing. He writes: 'Investing in bonds requires attention to more than one event at a time. Driving a car requires a foot on the gas, hands on the wheel, and eyes on the road. Navigating the bond market requires a foot on interest rates, a handle on the prospects of being repaid, and an eye on inflation.'

Fixed income guru: Andrew Carter

'If Andy Carter did not invent active fixed income management, he is one of its very earliest practitioners', comments Peter Bernstein, someone well qualified to observe fixed income history. And perhaps nothing epitomizes the development of investment management more than the changes in fixed income practice in the last thirty years.

Classic investment finance reserves the function of providing funds to run a business to equity. Borrowing, whether short-term or long-term, is matched to the payment flows of specific projects for interest and repayment of principal.

We have come a long way since this basic early understanding. Today, fixed income instruments have rather little to do with specific projects but are another device, like equity, to raise permanent capital. As such, bonds are expected to be refunded and bond quality is as much a measure of the likelihood of new investors to step forward to replace those who wish to move on to other investments as it is a measure of the profitability of business projects.

Bonds in the 1950s and 1960s were purchased by institutional investors for the major part of their portfolios and were normally held to maturity. These investors might have occasionally altered their quality preference, using rating agencies to attest to bond quality and covenants, but the modest changes they made were almost entirely through their selection of new issues. It was a slow, deliberate process. And expected bond returns were likely to be the coupon return to maturity and the repayment of principal. Many fixed income portfolios were carried on an institution's accounts at par or purchase price, unadjusted for fluctuations in market value. After all, there was unlikely to be a sale before maturity so recognition of market fluctuations by changes in interest rates or creditworthiness was immaterial.

Until the emergence of active fixed income management. Sometime around the bull market excesses of the late 1960s and the collapse of equities in mid-1970s, the thought occurred to Andy Carter and a few others that bonds presented an opportunity for swaps. By studying the underlying characteristics of one bond, it might be possible to find a comparable instrument at a cheaper price. And with the knowledge that a trade could be done with someone who lacked this insight, perhaps a small but promising gain could be captured. Thus, the bond trading business and bond capital gain business were born.

Andy Carter looks like a flashy, dour Scot. Wearing a signature bow tie, he is totally immersed in the full range of fixed income active management, having been there from day one. It tells us much about Carter that he followed his father as the top student at Loomis School and donated a residence hall there in his family's name.

Carter started in the investment business at Irving Trust in 1964. But his exploration into active fixed income management began with the Harvard University endowment in the mid-1960s. Just as interest rates began a huge rise, the opportunity was available to show how a bond portfolio could be energized by trading compared with the historic strategy of buy and hold.

Carter took active bond management to a new firm, Thorndike, Doran, Paine & Lewis in Boston and then started his own operation in 1972. At both places, he collected a blue chip roster of institutional clients who expected, and received a different style of bond management and paid equity-like fees for the service. He collected mandates of billions from demanding clients for management. Currently, he is chief executive officer of Hyperion, a bond management firm based in New York City.

Today, fixed income management is the most quantitative of investment disciplines, incorporating the most extensive use of sophisticated derivatives and advanced statistical techniques of risk management (see QUANTITATIVE INVESTING and RISK MANAGEMENT). However, the well-publicized near demise of LTCM was active fixed income management carried to its extreme. And Andy Carter can take the credit - or blame - for starting it all.

Counterpoint

One of the major disadvantages of investing in bonds is that they seem to underperform equities over the long term. This conventional wisdom is strongly expressed by Wharton finance professor Jeremy Siegel, who argues for the vast superiority of the equity markets as an investment vehicle. Siegel calculates that a dollar invested in a representative group of US stocks in 1802 would have grown to $559,000 in 1997 after adjustment for inflation (which reduced the value of the dollar to seven cents over that period). In contrast, a dollar invested in long-term government bonds, short-term bills or gold would have grown after inflation to $803, $275 and $0.84 respectively.

So while bonds are usually thought to be less risky than equities, in terms of inflation-adjusted returns, they have actually been more risky for most of the nineteenth and twentieth centuries. Siegel estimates that the real return on equities over almost two hundred years was 7% a year compounded, compared to 3.5% for bonds and 2.9% for bills. What is more, the superiority of stocks grows and their riskiness falls the longer they are held: they outperform bonds and bills 60% of the time over a single year, 70% over five years, 80% over ten years and 90% over twenty years.

The credit risk of bonds is a further downside, particularly during bull markets as investors become more willing to accept risk, which tends to reduce the spread or risk premium that poorer risks pay. When the market is jolted by bad news, the spread invariably widens again dramatically, causing the poorer risks to fail. Notorious recent examples include the aftermaths of the December 1994 Mexican devaluation and the August 1998 Russian default and devaluation. The latter led to the 'flight to quality' and widening of spreads that was such a problem for LTCM.

The old argument in favor of investing in bonds is that they provide current income and some degree of stability of capital. It is generally agreed that the shorter your investment horizon and the lower your risk tolerance, the higher the percentage of bonds you should have in your portfolio. But should the bond portion of a portfolio really be actively managed? Research suggests that professional forecasters find it difficult to beat a simple approach that always predicts that future interest rates are equal to current rates, and that after accounting for management fees, bond funds tend to underperform simple passive investment strategies.

Is the whole of active fixed income management a fraud perpetuated by managers to increase fee income more than the gains, even if achieved, that could result? Certainly, bond markets are thought to be very efficient and fees should be examined carefully and, ideally, avoided entirely if possible. For example, it is hard to see how management can increase returns when the yield spread between thirty-year corporate bonds and thirty-year treasuries is under 1%.

Then again, for individual investors, trading in the bond markets can be difficult since in many cases, the markets are not very transparent. While the bid-ask spread on US treasuries is small because of the very liquid market , the spreads on corporate and foreign bonds can be as high as 5-6%. This is because bonds are usually traded 'over the counter' with no real marketplace. Investors must rely on brokers who have a big incentive to give the bond seller and buyer the worst possible price in both directions as they make the difference.

Guru response

Andy Carter comments: 'I've always been amazed that people don't seem to realize that the US government is the biggest fraud in history. We generally did not pay our Revolutionary War soldiers at all, and what we did pay them with 'wasn't worth a Continental'. Another example: in the past thirty-five years, the US government has debased its currency by a factor of at least seven - but more probably ten-fold - thus defrauding all fixed income investors of the vast bulk of their investment.'

'It always amuses me that equities' long-term compound return is such a vastly high multiple of that from bonds in dollar terms, and yet the compound return stated as an annual percentage is only about twice as high. No one really gets to compound for very long. And the very fact that bonds are an inferior long-term holding argues that they probably should be given careful management. Someone does hold them, and that someone needs help all the more because bonds are a cheat.'

'The idea that the less than 1% spread between thirty-year treasuries and corporates means active management cannot increase returns seems untrue. One could hire a manager for probably fifteen basis points and thus capture the spread. During most of my career, the spread has been under 1%, but I have captured a significant alpha for my clients. They have enjoyed an almost 7% real after-inflation rate of return since 1969, when I first decided to work with the bond market rather than against it because bonds for the first time ever contracted a future rate of return equivalent to the past nominal return from equities. There are a number of publicly offered bond funds that have rather consistently and handsomely outperformed the bond market. PIMCO, Standish, Ayer and Loomis, Sayles all have such public funds.'

'Finally, I believe you overemphasize the significance of LTCM, which is indicative of very little beyond itself. They are a hedge fund - and a highly leveraged one at that - and not a fixed income management house.'

Where next?

While it is true that fixed income management is different than hedge funds, the issue of SEC registration is not really significant since it is more an issue of paperwork than a review of investment precepts. Hedge funds operating in bond markets have the same theories and practices as the most advanced fixed income people, so there is a direct connection between the development of active bond management and LTCM. The latter is an extreme case but it comes with overconfidence in the models, and with a large segment of bond and derivative managers using the same models at the same time since they share the same education and same databases.

While historically stocks have provided substantially greater returns than bonds, there still may be good arguments for fixed income investing. As the ads for investment products are all obliged to say, past performance is no guarantee of future performance, and many believe that bonds may outperform stocks over the next few years as stocks' recent strong performance makes them less attractive and as deflation becomes a more potent force than inflation.

Indeed, much of the recent interest on the plus side has been in the fixed income market. While the stock market has been demonstrating volatility and generally crashing in emerging markets, the US bond market has been steadily strong. There have been two unusual circumstances: one is an inverted yield curve, where long-term rates are lower than short-term rates; the other is a flight to quality, with the quality preference spread widening dramatically. These previously occurred together in 1981, a highly inflationary period, and in 1990, when inflation was declining yet clearly positive. But to find a precedent for both happening for a sustained period, we need to look back to deflationary times almost a century ago.

It seems to be conventional wisdom that the US and European economies are in a healthy state of moderate inflation. But perhaps instead, they are mixed economies with some features still experiencing inflation, principally wages and salaries, and others experiencing deflation, principally those associated with materials and commodities. Today's forecasts are that there is likely to be even more competition from lower wages from the developing countries, which are experiencing extremely heavy deflationary pressures - and that these pressures may spread to the developed world. With the reality of deflation plus relatively high real interest rates, bonds become very attractive.

The bond markets may also be boosted by the expansion of the eurobond market in Europe in the wake of the single currency. All new government debt in the eleven 'euroland' countries will be issued in euros, market practices will be harmonized giving incentives for more corporate bond issues in euros, and the market may become more transparent, liquid and efficient. It seems likely that the euro fixed income market will come to resemble the US bond market.

Finally, it is often valuable to challenge unchallenged precepts. One of the most widely accepted assumptions is that US government short-term debt is the riskless base against which all other returns are measured. But is that always so? Not necessarily: since US debt is almost perpetual and refinanced, what happens when the debt holders, often non-US lenders today, have other uses for their funds? The largest holders of US treasuries are Japanese and it is not difficult to imagine that they would have other uses for their funds than holding short-term US instruments. And if they and others withdraw from this market, the riskless security could become quite risky.

Read on

In print

Michael Lewis, Liar's Poker
Steven Mintz et al, Beyond Wall Street: The Art of Investing
Jeremy Siegel, Stocks for the Long Run: The Definitive Guide to Financial Market Returns and Long-term Investment Strategies

Online

economics.sbs.ohio-state.edu/jhm/ts/ - a website of data and tools for bond market investors
www.investinginbonds.com - Bond Market Association website with useful introductory material on fixed income investing