Strategy Monthly. Unfixed Income. May 26, 2015

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1 Strategy Monthly Unfixed Income The yield on traditional fixed income this year has been anything but fixed. From a low of. % on the last day of January, the yield to maturity on the ten year Treasury has risen by basis points to. % as of May. The thirty year bond yield bottomed on the same day at. %, and has since added basis points to stand at. % (as of May ). These rapid price moves are remarkable on their own, but are even more notable in that they occurred even as economic activity slowed to a halt in the first quarter. Bond investors are concluding that the Federal Reserve is not swayed by winter weather and transitory economic weakness, and therefore intends to begin raising interest rates, most likely at its meeting in September. In this and every economic cycle, monetary policy is guided by the twin mandates of the Federal Reserve to pursue price stability while maximizing employment. The Fed has defined success on the first of these two charges as core inflation of %, while leaving the definition of success on the second measure more ambiguous. Yet a cursory analysis of the labor market indicates that this aspect of the Fed s mission is largely accomplished. At. %, unemployment is back down to levels last seen prior to the financial crisis. The domestic economy added. million jobs in, up from. million in. Initial claims for unemployment are at a year low. Yes, concerns linger about the quality of jobs on offer, the decline in labor force participation and the rise of part time labor, but these concerns are not new or unique to this cycle. The strength of the labor market gives the Federal Reserve every reason to consider raising interest rates. But the lack of inflationary pressure does not require them do so. The Fed s preferred measures of inflation exclude the more volatile components of food and energy, and these core measures remain below the Fed s target of. %. The Core Consumer Price Index (CPI) and the Personal Consumption Expenditure (PCE) deflator have each lingered at or below. % since. Breakeven spreads in the inflation indexed bond market betray no signs of concern about rising prices anytime soon. The Federal Reserve seems to have concluded that unless and until there is price pressure in the labor markets in the form of rising wages, general price increases should remain subdued. This makes developments in the labor market all BBH STRATEGY MONTHLY / Unfixed Income 1

2 the more interesting. All else being equal, an unemployment rate of. % should lead to rising wages, as the supply of labor shrinks and employees are able to demand higher wages. And yet the laws of supply and demand don t seem to be holding in this cycle. The last time unemployment was this low (in the summer of ), nominal wages were growing at an annualized pace of. %, and we haven t seen that pace since. Two avenues for future wage pressure may help to solve this seeming paradox of stagnant wages and robust employment levels. First, although average hourly wages are rising only modestly, the length of the average work week has expanded over the course of this economic cycle. Companies are naturally reluctant to add new workers, along with the associated non wage costs, when they can get more hours out of their current workforce. At some point, though, the workweek can t expand any further, and hiring and wage increases ensue. Second, there is evidence of real wage pressure in higher skilled positions, but that pressure hasn t yet leaked into less skilled jobs in a meaningful way. We might be seeing, however, evidence of broader wage growth in the decisions of several major employers such as McDonald s and Wal Mart to increase their minimum wages. These and other companies have admitted the difficulty in identifying and retaining employees when job prospects at slightly more skilled positions have improved. The Federal Reserve knows this, and in its desire to remain vigilant on the inflationary front, is not likely to allow shorterterm economic weakness to divert its intent to begin raising interest rates this fall. Additionally (and perhaps more importantly), the Fed needs to restore a more normal level of interest rates for the simple fact that, at some point, the economic cycle will dictate that rates fall once again. At present, with rates anchored at zero, that particular monetary policy tool is unavailable. The current economic cycle began in June in the wake of the financial crisis, and is closing in on six years of duration. That is by no means the longest expansion on record, and the modest nature of this recovery indicates that what it lacks in vitality it might very well make up in longevity. Yet versus the post World War II average of months, this cycle is already slightly longer than average, and the Federal Reserve will at some point need a full complement of monetary tools to address the next downturn. Even as the Fed attempts to read the tea leaves and determine the appropriate timing and pace of a return to more normal interest rates, so, too, are bond investors figuring out how to position portfolios in such an uncertain environment. The result is that price volatility, a characteristic more often associated with equity markets, has come to define traditional fixed income. This provides a healthy and timely reminder that investors need to understand the various roles that fixed income assets play in a portfolio, and the tradeoffs that take place when allocating capital to fixed income investments. In a normal market environment, fixed income provides three benefits to a portfolio: it is a source of yield, a store of liquidity (ready access to your money) and an anchor of price stability. The economic crisis and the Fed s response to it have disaggregated those benefits, and they no longer come in a nice, neat package. Investors can obtain yield in fixed income securities by taking on credit or duration risk, but that yield comes at the cost of either less liquidity, more price BBH STRATEGY MONTHLY / Unfixed Income 2

3 volatility or both. Alternatively, investors can maintain a highly liquid portfolio of fixed income assets that evince more price stability, but that approach is devoid of yield. The Role of Fixed Income PORTFOLIO BENEFITS ASSET CLASS YIELD LIQUIDITY PRICE STABILITY Treasuries and Municipals Very little in the current environment. Negative real yields. Markets remain deep and liquid, particularly in shorter maturities. Good, but beware sensitivity to rising rates. Corporate Bonds Better yields, but still low in an absolute sense. Less liquidity than traditional fixed income. Similar sensitivity to rising rates at longer maturities. High Yield Bonds Better yields, but not reflective of default and price risk. Decent liquidity in fund structure, but markets can become thin in times of stress. Prices have volatility more similar to equities than traditional fixed income. Commercial Real Estate Cap rates low and opportunities thin. Illiquid. Prices appear more stable by virtue of illiquidity. Better inflation protection. And this is a global phenomenon, at least in developed markets. Central banks in Europe and Japan have followed the Fed s lead in driving short term interest rates to zero (or lower) while using their balance sheets to depress longer term yields as well. This is not new news. Global monetary policies have posed a persistent challenge to investors seeking a safe and predictable return from their fixed income allocations. Our concern is that unappreciated risk abounds in this asset class typically associated with safety, and that has led us to prefer the benefit of liquidity and price stability over the stretch for yield. By definition, fixed income investments provide a return that is fixed at the point of issuance, at least for those bonds held to maturity. With the exception of inflation indexed bonds, the coupon yield of a bond is furthermore set in nominal terms, so that inflation is the enemy of traditional fixed income investors. Inflation is fortunately not a very potent enemy at present, as outlined previously. Nevertheless, with yields so low to begin with, even a slight rise in inflation could negate the nominal return on offer in longer dated bonds. Furthermore, inflation risk can vary from investor to investor. If the ultimate objective of investing is to meet current and future spending needs, the inflation associated with those specific future needs is the relevant hurdle, and many costs are already rising more rapidly than the broad CPI indicates. Price risk, also called duration risk, is more prevalent as we near the onset of interest rate increases. Investors know that bond price and bond yields are perfectly inversely correlated. What is less obvious is how sensitive bond prices are to changes in yield when the yields start at such low interest rates. The sensitivity rises as duration or maturity increases, such that small changes in the market level of interest rates could easily exceed many years of coupon payments. For example, if an investor were to buy a year Treasury bond today, she would earn a yield of. % over the next year if there was no change in interest rates (scenario ). If, however, interest rates rose by just basis points (scenario ), her yield would be more than offset by a decline in price, leading to a total return of. %. As the table clearly shows, the longer the maturity or duration and the greater the increase in interest rates, the more severe the total loss. At an extreme, a year bond would result in a loss of close to % if interest rates were to rise by basis points over the next year. BBH STRATEGY MONTHLY / Unfixed Income 3

4 Total Return Scenarios Over a One Year Holding Period YEAR PORTFOLIO YEAR PORTFOLIO YEAR PORTFOLIO YEAR PORTFOLIO No change in interest rates 0.61% 1.56% 2.21% 2.98% Interest rates increase by 50 basis points 0.15% 0.32% 1.75% 6.14% Interest rates increase by 100 basis points 0.30% 2.17% 5.62% 14.58% Interest rates increase by 200 basis points 1.21% 5.81% 13.05% 29.60% As of May,. Sources: Bloomberg and BBH Analysis. That s not a likely scenario, to be sure, but it does illustrate the heightened sensitivity of bond prices to even modest changes in the market level of interest rates. This analysis says nothing about credit risk. If held to maturity we would expect these government bonds to mature at par and investors would receive their (nominal) money back, but the interim holding period would be quite painful. This is largely why we have preferred not to chase yield in our fixed income allocations. The risk of capital loss is simply too great, and we prefer the option value associated with shorter duration and higher quality fixed income investments. As interest rates return to more normal levels, the tradeoff of risk and return will become more appealing, and we will reintroduce traditional fixed income into portfolios. Investors should recognize that we are not, however, likely to return to the version of normal that existed prior to the financial crisis. For several decades leading up to the financial crisis, fixed income investors enjoyed the twin benefit of coupon yield and price appreciation as interest rates declined from the early s through the mid s. In an environment of rising interest rates even if the pace of the rise is measured that total return approach to fixed income investing will be less fruitful, as the majority of the return comes from yield and not price appreciation. At the risk of penning those most fateful words in all of investing, this time is likely to be different. Clients of Brown Brothers Harriman s Private Banking practice know that we believe that the ultimate objective of investing is the preservation and growth of wealth. Fixed income has played and will continue to play an important role in the pursuit of that objective, but the current investment environment requires patience and discipline. The primary role of fixed income in our clients portfolios at present is liquidity and price stability, as we deem the risk required to chase yield to be unacceptable. The current tradeoff of risk and return in traditional fixed income offers a timely reminder that there is no such thing as an inherently safe asset class: safety is always and forever a function of valuation, and at present valuations in fixed income offer little safety. G. Scott Clemons, CFA Chief Investment Strategist BBH STRATEGY MONTHLY / Unfixed Income 4

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