What is the real risk of fixed-income?

When a bond portfolio manager at a pension fund or mutual fund has money, her objective is to generate the highest yield and return for clients as possible. The reality is that these managers have hand cuffs on them. The handcuffs are called duration.

Several places on the internet explain duration:

“The duration of a financial asset that consists of fixed cash flows, for example a bond, is the weighted average of the times until those fixed cash flows are received. Duration also measures the price sensitivity to yield, the percentage change in price for a parallel shift in yields. The dual characterization of duration, as both the weighted average time until repayment and as the percentage change in price, often causes confusion. Strictly speaking, Macaulay duration is the name given to the weighted average time until cash flows are received, and is measured in years. Modified duration is the name given to the price sensitivity and is the percentage change in price for a unit change in yield. When yields are continuously-compounded Macaulay duration and modified duration will be numerically equal. When yields are periodically-compounded Macaulay and modified duration will differ slightly, and in this case there is a simple relation between the two. Modified duration is used more than Macaulay duration.”

Our point is that a bond index has a specific duration, and for the Canadian market it is about 6.25 years depending on which measure of duration we are talking about. Basically, if interest rates rise 100 basis points at every point on the yield curve, the price of the bonds would fall by around 6.25 percent. The average yield on the Canadian bond market (XBB-T) is about 4.5 percent, so rising yields is not good for existing holders. So there is clearly risk for investors that have seen bond yields fall for the past 30 years.

Bonds traditionally have been considered lower risk investments, but perhaps not for the next several years. Sure interest rate risk is one risk, but what about default? The reason the European Central Bank and the Federal Reserve are printing money to back the government bonds of the world is that if there is a default of major proportions, the stock market reaction following Lehman’s bankruptcy will look like noise. We hope that governments of the world get it, but they keep kicking the can down the road and have their fingers crossed. If you want a dry read, but a very good understanding of sovereign debt risk read: This Time Is Different: Eight Centuries of Financial Folly Carmen M. Reinhart & Kenneth S. Rogoff.

The government debt situation is a giant house of cards in our humble view and the Japanese economy is a basket case because of it—the US is close behind and worse when we factor in the unfunded obligations of past generations. It likely ends badly, but for now equity markets do not care. The liquidity of Quantitative Easing is trumping the risk, but that will not likely last forever. Let’s hope not, but let’s be prepared should it happen.

If you want to find out what we really think, attend one of our upcoming free seminars around the GTA and find out what you can do about it. Register here.