Rising Rates, Selling Pressure and Index Returns

At the beginning of May of this year the Federal Reserve first mentioned the idea of winding down QE3 by incrementally reducing the pace of their bond purchases. Since then, interest rates have re-priced to reflect this change and the 10 year Treasury Note has risen from a low on May 2nd of 1.626% to a peak of 3% on Thursday of last week (September 6th).  The steady climb over the last four months has caused droves of investor redemptions from bond mutual funds and municipal bond mutual funds in particular.  Net flows as reported by Lipper, YTD and since the beginning of June, are +$59.8 billion and -$17.4 billion for taxable bond funds and for muni bond funds -$20.9 billion and -$24.3 billion respectively.  This rush for the exit has caused additional pressure on markets, in particular the long end of the curve where prices are most sensitive to changes in interest rates.  A few sample long index performance figures are as follows:

  • BAML 15+ year Treasury index – current effective duration 16.73 years (YTD return  -10.699% & 3-mo return  -6.56%)
  • BAML 15+ year A-AAA corporate index – current effective duration 13.73 years (YTD return  -7.935% & 3-mo return  -4.383%)
  • BAML 15+ year national municipal index – current effective duration 10.98 years (YTD return  -8.142% & 3-mo return  -8.38%)

This highlights the risks associated with interest rate risk (duration) and the reason that we have held durations in our Core Short and Intermediate strategies to a fraction of the figures above.  It is important to remember that the yield curve has been very steep and is currently near all-time highs for that measure, so the incremental yield that can be captured by taking on some duration is material but the risk/reward for taking on too much is unattractive in this low-yield environment.  Investors in relatively shorter maturities can rely on our credit work and know that they will get their principal back with interest at maturity and have the opportunity to reinvest and earn a higher yield as rates rise.