Research

THE WARNING LABEL

It is no secret that the Federal Funds rate is extremely low.  It has been low for a while, and according to the Federal Reserve, should remain low through 2015.  After that, according to Warren Buffett, the billionaire chairman of Berkshire Hathaway Inc. it may be difficult for interest rates and inflation to remain low. 

Buffett believes low interest rates and inflation should dissuade investors from buying bonds and other holdings tied to currencies.  They are among the most dangerous of assets, Buffett said in a recent adaptation of his annual letter to shareholders. Over the past century these instruments have destroyed the purchasing power of investors in many countries, even as these holders continued to receive timely payments of interest and principal. 

High interest rates, of course, can compensate purchasers for the inflation risk they face with currency-based investments — and indeed, rates in the early 1980s did that job nicely, Buffett wrote. Current rates, however, do not come close to offsetting the purchasing-power risk that investors assume.  Right now bonds should come with a warning label (emphasis added).

While many investors clearly understand that low rates will not last forever, it becomes more difficult to determine exactly how this will affect any given portfolio.  The common understanding is that as rates rise, the bond prices will fall.  This is a fundamental characteristic of bonds which is calculated and quantified by the duration of the bond

In order to stay ahead of the trends, we have examined this scenario from several angles, with emphasis on how we expect our current managers to navigate the change.  The following is a graph of the Fed Funds Rate and the 10 Year Treasury Rate over the past few decades.  We identified four periods, highlighted in yellow, which experienced clear rate increases.   

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To isolate our managers’ performance tendencies during rising rates, we graphed the total return of some of our mangers, and three fixed income indexes, in each of those periods shown in the following chart.

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In these four periods of rising rates, we were pleasantly reassured that our managers had the acumen to navigate troubled waters.  This was accomplished by various techniques of managing bond types, sector allocation, duration, maturity, credit quality, country, and currency.  Out of 7 managers over 4 separate periods, only one manager in only one time period experienced a small loss.  That manager is a global fixed income manager who may have had other issues affecting performance other than US interest rates.  On a similar note, one of our emerging market debt managers added diversification and was able to return over 40% during one of the rising rate periods. 

 

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Next, we examined how a few of our Fixed Income managers performed across all markets in the past five years.  The upside/downside capture chart above is a graphical representation of this.   We were pleased to confirm that these managers have ALL captured at least 25% more upside than downside against the Bank of America 7-10 Year Treasuries index, and are head and shoulders above the 10+ year index.  In fact, many of our managers have consistently protected capital and even made money in these down markets.

While the upside/downside chart paints a detailed picture of how our managers have historically performed during periods of rising rates, we also wanted to isolate down market performance.  The result is displayed visually in the “Down Market Annual Return” graph (below).    Again, we notice that the majority of our managers have positive performance during difficult periods.

 

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After examining periods of recent interest rises from multiple angles, the Equitas selection of managers not only performed well during periods of rising rates, but has also managed to protect capital during down markets as a whole.   We take pride in our ability to select manager talent to manage our clients’ assets. 

Rates are just one of several factors that can be managed.  Managers with the ability to adapt to change, with the ability to manage portfolio risk factors such as yield, duration, allocation weighting, and credit quality, can find success in multiple environments.  If we go back to an environment like the 1970s, it may be difficult for any manager to navigate those extremes, but these managers have done well with the recent changes.

 
   

While we have evidence of our managers’ ability to navigate a rising rate environment, they might not, however, have to use that preparation anytime soon.  Ben Bernanke, chief of the Federal Reserve, has given indication that rates might not rise until 2015.  Bernanke says the Fed needs to drive down borrowing rates because the economy is not growing fast enough to reduce high unemployment, currently around 8%, to 6.5%.  This is known as the ‘Evans Rule’ put forth by Chicago Fed President Charlie Evans, who has long maintained that the Fed should promise not to tighten monetary policy until the economy hits specific economic thresholds.  In other words, rather than the Fed promising to keep rates low until 2015 (or some other arbitrary date) the promise is now to keep rates low until we’ve hit either 6.5 percent unemployment or 2.5 percent inflation.

 

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As we approach 2015, the Fed will no doubt offer more guidance.   The chart above offers some tentative guidance on when we will reach an acceptable level of unemployment based on how many jobs the economy adds every month.  Whether the economy returns to full capacity and interest rates rise to their historical averages, or we muddle through in a low growth scenario like Japan has done for over a decade, we believe our selection of managers has the skill to be able to navigate the markets.