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What does the bond investor do with rising interest rates? – Part 4 Currency management

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(publication date: 10 May 2017, original published on 7 April 2017)

The Dutch text version of this article can be found on: https://www.iex.nl/Column/262952/Wat-te-doen-bij-stijgende-rente-IV.aspx

Introduction

In our search for an answer to the question in the title, we concluded in Part Three that the Carmignac Global Bond Fund showed a rising net asset value during the last few weeks even though interest rates were rising at the same time. The fund can short the bond market. However the fund’s average duration was reduced to 0.12 years, which is a neutral position. So the recent positive returns could not have come from shorting the bond markets. This fund may also invest in other currencies and currently holds a strong position in other currencies. It is not just a bond fund, but a fund that can invest in interest-rate instruments in currencies other than just the €. And that brought us to the next chapter in our series: currency management.

Bonds denominated in other currencies than €

As an investor in the Netherlands, the purchase of bonds is naturally focused on bonds in €. You live and work in €, enjoy your retirement in €, your costs are in € and so you’re looking for income in €. But the interest you receive or pay differs for every currency unit. Even more, except for interest rates in Japan, interest rates in the € zone are lower than almost everywhere else in the world. And that is important because the value of currency units is strongly dependent on the so-called Carry trade possibilities.

Carry trade

Lets assume you borrow in the Netherlands € 10,000 for 10 years, and you buy $’s, which you then lend out interest-bearing for a period of ten years. Against your € 10,000 debt, you now hold a claim in $’s worth € 10,000. Net your possessions did not change because of thuis trade. This is called a Carry trade.

Interesting in this transaction is the fact that interest rates in the Netherlands are lower than interest rates in the United States. Suppose you could borrow the € 10 against the 10-year interest rate in the € zone and with the proceeds, you would buy US Treasuries with a term of 10 years. Then you pay (aside from costs and margins for risk and trade) 0.50% and you receive 2.35%, each year again. This gives you a gross return of 1.85% per annum without having to spend money (apart from any margin requirements). This transaction is difficult to enact for individuals. Costs and risk conditions make this a virtually impossible story. But for professionals who have access to institutional markets for currencies, derivatives and interest rates, the costs are significantly lower. To them this is a very possible trade.

Currency risk

In theory, the parties will buy the currency unit where the interest rate is higher and sell the currency unit where the interest rate is lower. For some time this has been the main reason behind the strength of the $ against the €. But only the sun rises at no cost. The downside is that exchange rates sometimes also move the other way. For in the end, a currency unit is also a product, that becomes more expensive when it gets scarce and vice versa. If a national bank or government prints too much of its own currency, then the value of that coin corrects and eventually it may even become worthless. This is the situation of (hyper) inflation. The paradox is that interest rates increase in times of hyperinflation, but never high enough to counteract the depreciating effect on the value of your coin due to that inflation.

Carry trades can therefore only be interesting when inflation in the two currency zones between which one speculates, develops more or less the same. And for this reason, a Carry trade between the $ and the € makes sense while a Carry trade between the € and the Venezuelan Bolivar is completely nonsensical, even though the interest rate in Venezuela is significantly higher than in the € zone.

There are many examples of people who bought a home in their own country (Poland, Hungary) and financed the purchase with a mortgage loan in another currency (for example, the Swiss Franc) because the interest rate in that currency at the time was so much lower than the interest rate in their own country and their own currency. All these people got into trouble when their own currency then devalued significantly against the Swiss Franc. The level of their debt (in Swiss Francs) remained the same, whereas the value of the collateral (their own house and their income) decreased significantly. In many cases the mortgage debt doubled in the local currency.

Interest differential between $’s and €

In graph 7 we have included a graph showing the difference between the 10-year yield in the € zone and 10-year yield in $’s (US Treasuries).
BLOG 20170407 FIG 7 EURO-DOLLAR
Graph 7.

Those who read our articles more often know this chart. It is one of the basic graphs in our analysis we use when looking at the currency risks in our clients’ portfolios. The top green curve shows the monthly development of 10-year interest rates in the € zone since 1995. The blue curve in the middle is the development of 10-year interest on US Treasuries ($’s) and the bottom line shows difference between these two. The red line is the monthly difference and the blue curve passing through it is an average of the red line. The difference has, in the past 25 years shown, never been as big as it currently is (in favor of the $). That the $ has been stronger over the past few years compared to the € should not be surprising. And the answer to whether this difference will increase further depends, of course, primarily on the policies implemented by the Central Banks in the US and in Europe and by what the respective governments will do in the coming years.

Government policy and QE-programs

The US FED several weeks ago for the first time discussed reducing its own balance sheet. Since 2008, the FED has conducted several QE programs buying a huge amount of US government bonds. For a while now, no new bonds have been purchased, but the bonds being redeemed are still being replaced by new bonds. As such, the FED does not add any new money to the market, but the previously created amount of money has not yet been withdrawn from the market. But in the first week of April, the FED announced that, at the end of this year, it would possibly stop replacing bonds in its own portfolio that are being redeemed by the US government. This is the final step (along with the already rising short term interest rates) in the US normalization process. In Europe, one has not yet gotten as that far into the process. Here still new bonds are purchased by the ECB every month. But the ECB has already indicated, that the purchase of new bonds will come to an end late this year or early next year. This means that the ECB is running behind about one year in its policy compared to the FED. So here too the end of the easy money era is nearing.

On balance, this phase difference argues for a constant or even increasing difference between the US interest rates and interest rates in Europe. This is also the reason why most analysts still expect parity between $ and € to be reached during the course of this year. The $ would, in this scenario, appreciate another 9 cents to the €.

Monetary financing of government deficits

But there is another source of new money in each country and that is the government itself. In the United States, since the independence in 1776, the dominant (Pavlov) reaction to any problem in the US economy has been to print $ ‘s. This has been a constant whenever the US government deficit grew significantly every time the economy got into trouble. Deficits of 8% or more per annum are no exception. In Europe, on the other hand, it is a legal requirement for governments to keep their deficit structurally below 3% per annum. If this deficit reaches 3% or more, national governments have to cut their budget. Now you will rightly say that several countries, like France for example, have never met this requirement. But these agreements in fact do create the situation that in France the deficits do not rise unreasonably high. All European governments (as far as they have the € as a their local currency) carry a statutory restrictive fiscal policy. This leads to a structurally lower inflation rate in Europe, and thus a structurally lower interest rate, and at the same time a structurally stronger currency compared to the $.

In this picture, the $ may be stronger than the € from time to time, mainly due to the fact that the interest rate differentials will increase, but in the long run the € will become stronger and stronger. Even if parity will be reached, that will only hold for a relatively short period. One should rather expect the € to reach $ 2 for each € in the long run.

Currency of safety

But of course there is another third, not unimportant problem for the € and that is the problem of trust. Whoever spoke to American analysts this year will have heard without exception that in the U.S. the question is not asked whether the € will survive, but only when the € breaks apart. Every time a crisis occurs in the world, the $ is always a point of refuge. The $ is therefore the most important reserve currency in the world, which generates strength. If the discussion about the survival of the € zone is not stopped then that will keep the € under pressure. In this sense, the elections in France, Germany and Italy are extremely important this year, and the discussion about Greece, which recently reemerged, is also important.

Carry trades and currency risks

All these considerations are essential when investors decide to expose themselves to the risks in other currencies through Carry trades. And then we have not talked about the British Pound, the Japanese Yen, Mexican Pesos, the Brazilian Real and so on. It is a completely different game than investing in equities or bonds. But if you wish to invest in bonds that are out of the € zone, you should not underestimate currency risk. We therefore encourage you to hand over active currency management, in case you invest in bonds, to a professional party (a wealth manager or investment fund) such as the Carmignac Global Bond Fund that we discussed in our previous article in this series.

Bonds denominated in other non-€ and non-$ currencies

But there is yet another possibility. Consider (by way of an example, there are many more such funds) the db x-trackers II Emerging Markets Liquid Eurobond UCITS ETF. This is an Exchange Traded Fund (ETF), a tracker, which invests in a portfolio of bonds from countries within the Emerging Markets category. The fund is an index fund, which means that there is no active investment policy, but a predefined index is followed. In this case, the “Deutsche Bank Emerging Markets Liquid Eurobond Index” is followed. The index includes government bonds and government-guaranteed bonds denominated in €, US $, Japanese Yen, or British Pounds, with the fund hedging the $, Yen, and Pound risks. As a result, you have a portfolio without currency risk of bonds guaranteed by Emerging Markets Guarantors. The most recent overview, which we have taken directly from the fund’s factsheet dated 28 February 2017, is shown in Figure 8. Half of the fund is invested in government bonds or government-guaranteed institutions from Mexico, Poland, Turkey, Indonesia and Brazil.
BLOG 20170407 FIG 8 Spreiding db x-tracker
Graph 8.

db x-trackers II Emerging Markets Liquid Eurobond UCITS ETF

The fund’s ISIN code is LU0321462953. The fund does not pay-out any dividends, so any interest income generated remains within the fund. Each year, a percentage of 0.55% of the fund will be charged as costs and you will incur transaction costs when purchasing or selling the fund. The bonds held have a rating of B3 up to A2, all investment grade thus, with the bulk (89%) Ba2 or better. The average coupon is 4.68% (this varies in time of course) and the duration is 6.6 years. The fund invests by default in bonds with maturities of 5 to 30 years and strives for an average repayment period of 9 years. This is the first hitch as even though the average maturity is relatively low at the moment, it is still high if a worldwide increase in interest rates is expected.

Synthetic tracker

A second issue is the fact that this is a synthetic tracker. The index is imitated using derivatives. The fund itself does not buy the relevant bonds. Instead, the fund buys the investment grade bonds and holds deposits in the money market, and then hedges this portfolio using derivatives purchased from Deutsche Bank, the parent of the issuer (Deutsche Bank Asset Management AG) in order to generate the index-related risk it propagates. The basis of the portfolio is therefore relatively safe, but you do have the counterparty risk of Deutsche Bank.

Regular review of the underlying index

A third potential problem is the fact that the underlying index is determined by Deutsche Bank itself and that this index is revised at least once a year. DB may even revise the index every month and it is not easy to find out what exactly the rules are for this review. DB writes itself: “The Index follows a rule-based strategy that cannot be adjusted to take into account changing market conditions. It is therefore possible that you do not benefit from such a change or that you are exposed to risks that could have been avoided by an active investment manager.” But what exactly these rules are, is not included.

Actual performance – price chart

The fund was founded in 2008 and has a listing on the Xetra, Swiss SIX and Italian stock exchange. It is also available in the Netherlands, but not every bank gives its investors access to trackers on the Xetra, so whether you can buy them at your own bank is uncertain. At Binck Bank, the tracker can be bought.
BLOG 20170407 FIG 9 DB X-TRACKER EM M BONDS
Graph 9.

Graph 9 shows the price development of this fund. We have drawn a rising trend line that reflects an average historical return of 5.2% per annum. This includes all fund costs, but transaction costs are not taken into account. We measured the return during the period from 1 August 2008 to 31 March 2017, 8.67 years. But investing in Emerging Markets, even when it comes to bonds, is never without risks. Look at the losses that occurred in 2008 (a decrease of 33.5%) and in 2013 (a decrease of 19.5%). In balance, little has happened because the prices of these types of bonds recovered fairly quickly. But if the price drops, then it’s fast! At the far right of the chart one can also see a smaller decrease. This drop is due to the rhetoric  of President Trump against Mexico, which led to a sharp fall in the value of the Mexican Peso and a simultaneous rise in interest rates in Mexico, and since this index is invested in Mexican bonds for more than 10% and also has a relatively long average maturity, this event had a significant impact on the net asset value of this fund. The figure shows that there are long periods during which no returns are generated, for example, the fund did not yield any returns between 2014 and the beginning of 2016. Meanwhile, interest rates came in (which thus led to price losses) and also costs kept being charged by the fund manager. And who bought the fund at the end of 2012 had gained nothing after 4 years, late 2016, due to President Trump’s election.

Other trackers in this area

Of course this is not the only tracker of its kind. In Figure 10 we give you another example. It isn’t completely comparable, which shows another problem to these types of funds: you need to do your homework first to find out what exactly you are buying. Now we show you the price development of the iShares JP Morgan US $ Emerging Markets Bond ETF. The ISIN code of this fund is US4642882819. The fund is listed in US $, a physical tracker (actually buys the bonds in the index) returns dividend (currently about 5.1% per annum) but has a completely different composition than the db x tracker which we discussed above. For example, the biggest country position is Mexico, but by only 6.3% (April 6th) it’s still significantly less than the db x tracker holds. Poland, Turkey, Indonesia and Russia, the JP Morgan trackers has an exposure to each of these countries of between 3.9% and 5.1%. The diversification of country and currency risk is therefore much better, but the average risk is still higher in terms of rating than with the db x tracker. This is because there are also countries in this fund, the risk of which is CC to BB. As such 2.2% of the fund is invested in Venezuelan bonds, something that does not happen at Deutsche Bank’s fund.

In addition, the duration is 6.94 years, the average duration is more than 10 years and the costs within the fund (the Expense Ratio) is 0.59%, with the Fund on its website indicating a discount of 0.19%. So the actual costs would be 0.4% per annum.
BLOG 20170407 FIG 10 ISHARES JPM ETF
Graph 10.

In the top half of the graph, you’ll see the fund’s development in US $. The fund returns dividend each year, which distorts the picture compared with Figure 9. The price is now moving fairly sideways, but with a dividend yield of approximately 5.1%, this does not differ significantly from Deutsche Bank’s tracker performance. But in the lower half of the chart we converted the rate into Euro. And now it makes a difference, because in this period the € has fallen on average, so you also benefit from the $ increase in the price. That adds a lot to the return, but the comparison is no longer fair. Because in fact you now have a $ investment. If the $ risk is to be hedged, then the interest rate differential per annum (figure 7) now costs about 1.85%. And then you do not have a better investment here, because that 1.85% must be deducted from the dividend yield of 5.1%!

Conclusion

Due to the relatively high interest rate, investment in government bonds of other countries without currency risk is a good alternative to investments in larger-country bonds in the € zone. But do not do it yourself and do not do that for the complete portfolio. Because you have a relatively large maturity risk and Emerging Markets are much more vulnerable to political and other uncertainties than others such as Germany, the US or other major economic powers. So use a tracker, knowing the funds listed here are just examples. As to our preference, we prefer the Deutsche Bank tracker. The fund is listed in €, the maturity appears to be somewhat shorter and the composition of the portfolio is better in terms of credit risk.

Next subject

And that takes us to the next subject in this series. Instead of going for maturity risk, one could also look for credit risks. In a next article we will discuss how some fund managers use active or passive management of credit risks to generate consistent returns.

The Hague, 10 May 2017
Gijsbrecht K. van Dommelen
Vladeracken Vermogensbeheer

www.vladeracken.nl

Disclaimer
The author is responsible for the investment policy at Vladeracken BV, an asset management company licensed by the AFM. Vladeracken invests and / or has invested in the securities discussed herein on behalf of its clients. This piece is not an investment advice. Whoever invests in the securities discussed herein and in accordance with the methodology and arguments discussed, or wants to invest accordingly does for his or her own accountability and risk. In this context, the author and Vladeracken BV disclaim all responsibility for the contents of this article. The securities and methods discussed represent a high risk.

What does the bond investor do with rising interest rates? – Part 3

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(publication date: 17 March 2017)

The Dutch text version of this article can be found on: www.iex.nl

Introduction

Before you is part three of a series of articles in which we discuss how you as an investor can deal with an environment where long-term rates rise structurally. In Part 2, we discussed two funds in order to clarify the differences in maturity strategy. We concluded that an ordinary bond tracker generates far too much risk for the investor, while the investor doesn’t know he or she holds a portfolio, whose duration is currently getting longer and thereby increasing its interest risk. Conversely we discussed a fund in which the duration is adjusted actively by the fund manager, Robeco Lux-O-Rente Fund. This fund can protect itself against rising interest rates by reducing the duration to zero. But the disadvantage of such a fund is that it takes time for it to align its strategy (the first phase of a rise in interest rates always costs money) and that it cannot go short in the bond market. In such a case, the fund may well avoid that it will lose even more money while rates are rising, but the fund it will still not be able to make money when interest rates rise. The question with which we ended Part 2 and begin this article is thus: are there funds that do make money when interest rates rise?

Buying funds that can short the bond market

In August 2015 we published an article in which we discussed this question. In this piece, we first consider the question of what it means to be “short” in bonds and what the risks are that belong to this type of investment strategy.

To be able to go “short” in a bond one has to borrow a bond from an existing owner, sell this bond and then at a later date repurchase the bond in the market (preferably at a then lower rate) and then return the bond to the person from whom the bond was borrowed earlier. This is the underlying process that lies at the basis of every product that allows you to go “short”.

In our article, we then tackled a number of problems, that will be faced when going “short” in bonds such as:
• The person who lends you the bond will charge you the interest on the bond that is built up during the time the bond is borrowed;
• You may be unsuccessful and the price of the bond may rise during the time you borrowed the bond;
• Borrowing bonds as such costs money;
• By the time you have to give back the bond it may no longer be available;
• The chance that you are right also has a price.

For a detailed explanation of these points we refer you to our earlier article on this subject (see the link attached to this sentence) and will therefore not go into this in this current article. But one should read the earlier piece as it is important to be aware of the risks associated with going short in bonds.

Bond funds that can short the bond market

There are both funds that track an index (ETFs) and funds that actively deal with the possibility to short the bond market (funds think they can offer Alpha by introducing their own active strategy). Trackers are usually cheaper (lower expense ratio) but they must abide by a pre-determined index or strategy and therefore cannot at their own discretion change the strategy. If you think rates will go down and you own a tracker that tracks an index, you cannot expect the administrator of this tracker to sell the underlying investments, you need to sell the fund yourself. In an actively invested fund, the fund manager may sometimes, based on his own analyzes, sell the underlying values and repurchase other assets. Your asset manager (such Vladeracken), can also execute such strategies.

Trackers that short a market or index

There are ETFs that follow the exact opposite strategy of the underlying index. If the underlying index rises, then the value of the fund drops. If the index falls, then the value of this fund increases. In fact, such a fund will constantly short the relevant index. The problem of “continuously shorting a market” is that this is only possible by making use of derivatives. These funds as such will always be “synthetic trackers” (see our article from 2015). And that automatically creates, in the case of short positions, the risk of contango. And we wrote: “This is the risk that arises because the term used should always be extended again (rolled). The problem signifies that funds that short an index will fall in value by definition, unless the underlying asset does what the short investor bargains for, which is a drop in the price of the underlying asset. So if the price of the underlying asset remains the same, the price of a short-tracker will still gradually sink. This is a direct result of all the costs associated with short selling of securities or other financial values.”

Using a tracker to benefit from rising interest rates therefore requires the investor that he himself has an active interest rate policy in order to actively buy and sell the tracker! Short trackers are not a “ buy-and-hold” -investment.

Trackers that short the bond market

In 2015, we discussed two trackers that short US government bonds (Treasuries). In these two trackers the investor is also exposed to a currency risk (US $). As we continue the sequel of this series, we will come back to these two trackers because the currency risk adds an additional risk. We will first focus on a tracker that shorts € bonds:

Lyxor ETF Daily double Short Bund (ISIN-code: FR0010869578)

This is a created by Lyxor, an ETF-specialist. The tracker is listed on the Paris Stock Exchange (Euronext). The fund takes on a daily double short position on the German Bund Index. That means that 1% depreciation of the Bund Index should provide an appreciation of the tracker of 2%. This is therefore a fund with a leverage of 2. This provides an additional risk because the leverage also works the other way. In addition, this is a synthetic tracker. The short position is built with derivatives in the Bund Index. They need to be replaced regularly (the position is adjusted on a daily basis) and that costs money. How much money can be seen in Figure 5.
BLOG 20170317 FIG 5 ETF BUND SHORT
Figure 5.

At the top of the graph we have drawn the price development of the German Bund Future. The bottom of the graph shows the price performance of the Lyxor Tracker. Between 2010 and 2016, the Bund future rose from a peak (in this chart the first) of 135 to a peak of 169 in June 2016. That’s an increase of over 25%. The tracker fell during that period from a price of € 80 to a low of € 36, a decrease of 55%. That is more than double the increase. The difference is in the cost of the tracker itself and the costs of having to maintain and role over the derivatives that keep the fund short in the Bund market.

Timing is important

The Bund Index is an index of German government bonds with an average maturity of 10 years. For a detailed description of the index and futures on this index we refer to an article that we publish at the end of August 2015 (part 6 of the series of 2015). Suffice it to say that this index behaves like the price of a 10-year German government bond with a coupon of 6%. If interest rates rise, then this index drops, if the interest rates fall, the index rises. In the graph, we have highlighted three periods when interest rates rose (A, B and C). In all three periods the price of the tracker (at the bottom of the chart), in fact rose. But the graph also shows how important timing is. The interest rate increases have occurred at a much quicker pace than the rate cuts and so to earn money you had to time both the entry point and the exit point particularly well. And that is extremely difficult, if not impossible, for most investors.

Head-and-shoulder and double bottom formations

But the chart also shows something else. In the top right part of the graph, we have highlighted a head-and-shoulder pattern. The Bund Index has almost finished a topping formation in the form of a left shoulder, a head and a right shoulder. The support line, where the index currently trades, is called the neckline. A break down is a statistically significant event. If that happens, a price target can be calculated for the Bund of 149! That is a decrease of 6.3%, which coincides with the support generated by the peaks of 2013 and the bottom in 2015. For the tracker, this means a potential price increase of over 12% from the current level of around € 39 (a target of € 43 to € 44). That is lower than the peak reached in 2015 when the Bund also fell to 149 points, because at that time the tracker recorded a high of € 48.50!

Conclusion as to short-trackers

In the short term this type of trackers can provide a solution, but they are by no means an instrument to hedge a long-term bond portfolio. Moreover, you yourself have to keep an eye on the right timing and that can sometimes be dependent on specific days. Most investors have too much distance to the daily business on securities markets and should not start involve themselves with these instruments.

Professional investors

For professional investors such as fund managers, things are different. They can act directly in the market for Bund Futures, they can keep busy all day with these markets and they can thus develop an active strategy to hedge the risk of bonds with derivatives or even actively try to use phases in which interest rates rise to generate profits. However they must have the opportunity to implement such a strategy. We have already seen that a fund such as Robeco Lux-O-Rente Fund may be able to carry an active strategy, but that on the basis of the prospectus this fund may not go short in bonds. They can never make money when interest rates rise, they can at best prevent them from losing money in such periods stages.

Investment funds that can actively short bond markets

A fund that can actively short bond markets (and which we have discussed earlier) is the Carmignac Global Bond Fund. At that time we concluded that the managers of this fund, although they were enabled to go short in bonds, had not exactly proven, that they were able to use this option in a lucrative way in the past. But a change seems to have taken place. Please refer to Figure 6, where you will find the price performance of the fund.

Carmignac Global Bond Fund (ISIN-code: LU0336083497)
BLOG 20170317 FIG 6 CARMINGAC GLOBAL BOND
Figure 6.

This is the share class of the fund, on which no dividends are paid, a real interest rate growth fund. In the top part of the graph, we have again drawn the Bund Future. To the right in the figure we have again shown the neckline of the top pattern which we have already described in Figure 5. At the bottom of the figure one can see the price performance of the Carmignac Global Bond Fund. In this figure we have marked two periods in which the interest rates have risen earlier. One period is the period between 2010 and 2011 and period B, a much shorter period, depicts the brief rise in interest rates in 2015. Both phases show a fall of the share price of the fund similar to that of the Bund future. So the managers have apparently made the assessment that the interest rate increase would be relatively short-lived and that therefore there should be no attempt to take advantage of the increase. Here is a disadvantage of a fund that follows its own active investment strategy. Their expectations could be wrong!

In both cases one can see that the price of the fund still keeps falling even after the interest rates reverse their direction. Apparently ultimately the fund managers do fit the strategy and it takes them time to adjust their strategy to the right direction of the market. This is a problem that we have also seen in the Robeco Lux-O-Rente Fund. Most active fund managers use models to determine the direction in which they should invest. But models are usually tracking systems and thus have the disadvantage that they are always slow to respond to new developments.

This is probably the reason why Carmignac has not been able to profit from the interest rate increases in 2010 and 2015. But 2016 shows a very different picture. While the Bund Future clearly makes a topping movement and is now declining, the price of the fund has kept on rising steadily. They now benefit from the rise in interest rates!

Premature conclusion

However our conclusion may be somewhat premature. Because this fund invests not only in € denominated bonds. The fund has the possibility to reduce the average maturity of the bond portfolio to minus 4 years. Thus it can short bonds. But in the same prospectus it is indicated that the fund may also invest in currencies other than the €.
In its most recent monthly report (late February 2017) Carmignac indicates that the average duration of the portfolio is 0.12. This is almost zero, not negative!

Conclusion

So on balance, currently the fund isn’t shorting the bond market. But the report also shows that the fund holds approximately 42% in $ denominated bonds, holds a short position of 5% in the British pound and is even 8% short in the yen. The current appreciation of the Fund is due to the fact that it does not lose money at a time when interest rates rise, and that meanwhile the fund makes money by running an appropriate currency strategy!

So its profit stem from the mix of currency investments, not from the rise in interest rates. So the fund is doing the correct thing, but you have to remember as an investor that you have an additional risk here!

Next week we will therefore consider the next strategy, which many bond funds have available, which is an active currency strategy.

The Hague, 17 March 2017
Gijsbrecht K. van Dommelen
Vladeracken Vermogensbeheer

www.vladeracken.nl

Disclaimer
The author is responsible for the investment policy at Vladeracken BV, an asset management company licensed by the AFM. Vladeracken invests and / or has invested in the securities discussed herein on behalf of its clients. This piece is not an investment advice. Whoever invests in the securities discussed herein and in accordance with the methodology and arguments discussed, or wants to invest accordingly does for his or her own accountability and risk. In this context, the author and Vladeracken BV disclaim all responsibility for the contents of this article. The securities and methods discussed represent a high risk.

What does the bond investor do with rising interest rates? – Part 2

/in , , , /door

(publication date: 10 March 2017)

The Dutch text version of this article can be found on:
https://www.iex.nl/Column/262110/Wat-te-doen-bij-stijgende-rente-II.aspx

Introduction

Last week we started a series of articles in which the central question is, what investors should do in an environment where interest rates rise structurally? In part 1 we discussed the current yield structure, the relationship between the US and European interest rates and our view on interest rate developments in the (near) future. We ended with the promise that we would discuss a number of bond funds in the next part of this series, with special attention to the question whether or not these funds are able to take advantage of rising interest rates.

Interest rate strategies

In order to understand the differences when comparing bond funds, it is important to have some insight into the various rate strategies that are used, as they largely determine the extent to which bond mutual funds are exposed to the risk of rising interest rates. Therefore, we will also discuss the following strategies:
·    Term Strategy
·    Credit Strategy
·    Currency Strategy
In this article we confine ourselves to the term strategy, but in the next articles we will come back to the other two.

Term strategy

The first choice to make as a bond investor is to chose the maturity of the bond he intends to buy. In Part 1 of this series we showed you a price chart (Figure 1) of a bond from the Dutch government with a remaining maturity of 20 years (until 2037). This bond is extremely sensitive to fluctuations in interest rates. You could instead opt for a bond that will mature in just two years. The interest rate risk for this bond will be much less because the bond will already be repaid after two years. If the interest rate has risen in the meantime, then you are missing only the extra yield for 2 years because you can reinvest the money after redemption in 2 years at the then higher interest rates. The 20-year bond however will only be redeemed in 20 years and so you need to wait much longer and will thus miss out on the increase in interest rates for a much longer period.

No active interest rate policy

There are bond investment funds that can actively manage the duration of their bond portfolio and funds that cannot do so. Especially trackers (also called ETF), funds, that merely follow a specific index, do not actively change the average duration of their portfolio. As an example we will discuss the iShares Core Euro Government Bond Fund (ISIN-code: IE00B4WXJJ64) This is a tracker on European Government bonds denominated in €. This fund will get you the average return of the total market for Euro Government bonds. French, Italian and German Government bonds are a relatively large part of the portfolio (65.8% of the Fund together in total). The term of this portfolio (the “duration”) is equal to the average duration of the total of all European government bonds. As the long-term interest rate is very low, the proportion of long-term bonds in the issuance programme of European governments for some time now is on the rise. And so the average term of this index, and thus of this Fund, slowly rises. The weighted average duration of the portfolio is now 9.1 years, the “option-adjusted duration” is 7.3 years. Note that historically, the average duration of the entire bond market has been around 4 years.

Option-adjusted duration

This is a measure of the average maturity of a bond, taking into account the redemption date as well as all coupon payment dates. But as the date of maturity in this definition one uses the first call date. In some cases, it may be that a bond is callable prior to its final redemption date. The bond issuer then holds an option to call for redemption prior to the latest day the bond must be redeemed. The date of early repayment is the call-date. So in this case the first of such dates is used.

iShares Core Euro Government Bond Fund

The weighted average “yield to maturity” of this specific Fund is 0.63%. That means that you may expect a return (yield) of 0,63% a year during the next 7.3 years (the option-adjusted duration of the fund). This fund will pay interest every six months and does not classify as an interest growth fund (in which case the interest received within the fund is added to the net asset value of the fund and as such is kept within the fund). The fund also lends a part of its portfolio to third parties and has built an additional risk into the fund which has nothing to do with the underlying index. The cost of this fund amounts to 0.2% per year (Expense Ratio). But with a duration of 7.3 years this is an investment with a relatively high interest rate risk. As interest rates rise, the price of this Fund will fall!

Active interest policy, but no “shorts”

There are also funds that can actively change the duration in the portfolio to their sole discretion, but that can only diminish the average maturity back to 1 day. If a portfolio has an average duration of 1 day, then there is no interest rate risk. Every day you will get your money back and that enables you to reinvest the money at a higher interest rate on a daily basis. The price of a fund with duration of 1 day may not drop once interest rates go up. A fund that in our eyes over the years, has shown that it has been able to cope well with this freedom is the Lux-O-Rente Fund of the Robeco-group.

Robeco Lux-O-Rente Fonds (ISIN-code: LU0792901570)

In Figure 3 we show the performance of this Fund together with the development of the 10-year yield on €-zone government bonds. The graph encompasses period of more than 17 years.
BLOG 20170310 FIG3 LUXORENTE
Figure 3.

To start, this is an interest growth fund. It pays no dividends or interest. The internal costs amount to 0.53% per year, considerably more than the tracker, which was discussed above. This fund has a computer model that determines how long the duration of the portfolio should be. The term may not be negative, but it can be stretched to indefinite in principle. The Fund uses a benchmark, which at the end of January had an “option-adjusted duration” (see above) of 7.8 years, almost the same term as the iShares Euro Core Government Fund. But the fund itself currently has a much shorter option-adjusted duration. On 31 January 2017 (last publication date) the option-adjusted duration of the fund was only 1.8 years!

On the right of the graph we have drawn several vertical lines. They mark the periods in which long-term interest rates fell or rose. For a more detailed analysis we refer to our previous articles about Lux-O-Rente and other bond investment funds. Any model will need some time to adjust to changing trends. There for they will usually lose money at the beginning of a change in direction, in this case when rates start to rise. At line E interest rates in 2016 started to rise again. Initially the fund incurred a significant loss, but the price has now, in 2017, stabilized, even though interest rates climbed further. So no further losses are incurred, but the fund cannot make money as long as interest rates rise (other than the actual interest it receives on its portfolio).

For comparison, we have included a shorter chart in Figure 4 (a daily chart) and we now have included the performance of the iShares Euro Core Government Bond Fund. Remember that this last Fund will pay out dividends and Lux-O-Rente will not. Comparing the price return on a longer term without correcting for dividend payments is not accurate, but here we mainly wish to show the sensitivity of both funds to longer term interest movements.
BLOG 20170310 FIG4 LUXORENTE
Figure 4.

The graph shows the period since June 2016 when long-term interest rates in Europe reached their lowest point and began to rise. The comparison is clearly negative for the Robeco fund. Because Lux-O-Rente lost relatively more in the beginning, when interest rates began to rise. But now while the interest has kept increasing, one can also see that the price is no longer responding to the interest rate rise. Since December 2016 the value of the Robeco fund barely changes whereas the price of the tracker continues to fluctuate. As interest rates continue to rise (and that is what we expect it to do), the price of Lux-O-Rente probably will keep moving horizontally, while the value of the tracker will again come down. The duration of Lux-O-Rente is now brought back to less than 2 years, the term of the tracker is still 7.8 years. And then the comparison will turn positive for Lux-O-Rente.

Subsequent conclusion

It is clear, that neither fund will enable you to take advantage of an interest rate rise. Lux-O-Rente is more expensive than this tracker, but in the past Lux-O-Rente has shown it has a lucrative interest rate strategy. The risk of this strategy lies in the delay built in its reaction to interest rate directional changes. It (Lux-O-Rente) will always miss out on the first movement and thus will lose its investors money. In the tracker the administrator does not actively manage the portfolio and as such the tracker will hold the maturity of the underlying index. The internal costs are clearly lower, but as interest rates rise, you will structurally keep losing money.

In part three of this series, we will discuss an example of a fund that can short the bond market. This Fund should be able to earn money in an environment in which interest rates increase on a structural basis.

The Hague, 10 March 2017
Gijsbrecht K. van Dommelen
Vladeracken Vermogensbeheer

www.vladeracken.nl

Disclaimer
The author is responsible for the investment policy at Vladeracken BV, an asset management company licensed by the AFM. Vladeracken invests and / or has invested in the securities discussed herein on behalf of its clients. This piece is not an investment advice. Whoever invests in the securities discussed herein and in accordance with the methodology and arguments discussed, or wants to invest accordingly does for his or her own accountability and risk. In this context, the author and Vladeracken BV disclaim all responsibility for the contents of this article. The securities and methods discussed represent a high risk.

What does the bond investor do with rising interest rates? – Part 1

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(Publication Date: February 24, 2017)
De Nederlandstalige versie is op 6 maart 2017 verschenen op www.iex.nl.

Introduction

In 2015 we wrote a series of articles in which we wondered what the bond investor should do in an environment where interest rates do not structurally fall, but instead rise over a long period of time. Like many, we were on the early side, but now this question has become extremely relevant.

The risk of an interest rate rise

Figure 1 shows (top) the price development of a government bond which is issued by the Dutch government in 2007 with a term of 30 years at the time. The remaining term is now 20 years and the loan is still considered long term. At the bottom of the figure one will find the development of the 10-year rate for €-denominated European government bonds.
BLOG 20170224 FIG1 RENTE
Figure 1.

In the graph we drew red vertical lines to distinguish the periods when interest rates rose from the periods in which interest rates fell. It needs to be noted that the bond is sensitive to the interest rate of the same maturity, now 20 years. That is not the same interest as the 10-year rate we used in the graph.

Structures and interest rate spreads

The longer the duration, the smaller usually the extremes in movements of interest rates will be. The development of long-term rates is an expression of the expectation of the markets as to the future development of short term interest rates. Market participants will always ask themselves whether the ECB and the Fed and other central banks will raise or lower interest rates in the (near) future. If one expects that interest rates will rise in the future, then yields on the long end of the bond market will lead the way by rising earlier. But investors also know that interest rates over a period of 30 years from time to time will drop again. At the peak of the interest rate cycle therefore 30-year yields will have risen less high than the 10-year rate. This is referred to as an abnormal, also called inverse situation. Normally, the 30-year interest rate should be higher than the 10-year bond yield as the risk that you will lose your money after 30 years is always higher than the same risk when having a term of 10 years.

Back to the graph in figure 1

What the graph does show is that an increase in interest rates will lose the bond investors money. If interest rates rise the price of the bond drops. This calls for a nuance. The price declines mainly take place in bonds with long to very long terms.

The graph also shows something else: the bond price is at a support level and a real breakthrough downward has not happened yet. The 10-year yield however has already broken through the resistance of 0.6%. Where 10-year yields rose further in recent weeks, the 30-year interest rate that did not.

And finally, the graph also shows once again that as yet no bottom pattern in the interest rate can be seen. To date, the tops again and again have been lower (lower graph) than the each previous top and bottoms and again and again came out lower than the foregoing bottoms.

The end of QE

But graphs are not everything. Last week an ECB member announced that he believes the European QE-program is nearing its end. And a member of the Fed in the U.S. went further by saying aloud that the Fed is close to the point to shorten its balance sheet. Virtually every analyst agrees that the European and American central banks face a normalization of their policies. In Europe, this means little in the short run, as Draghi has indicated that he will keep buying bonds until the end of this year. But the amount is less and whether he can continue this program in 2018 is becoming less likely. The Fed has already stopped buying loans, but so far has replaced the loans it has in its portfolio when they matured. Reducing the balance sheet means that they will also stop replacing loans. If that happens, then the potential inflationary risk from all that cheap money is reversed. After all, the Fed then pulls previously created money back out of the economy through the repayments on the loans it holds.

“When QE is stopped, interest rates will rise again”

That is the prevailing opinion amongst analysts. But whether this will be true is questionable. The expectation that the end of the QE program will lead to an increase in interest rates, is a self-fulfilling prophecy. If investors expect it, they sell long-term bonds, so the price of these bonds drops and thus interest rates rise. But then once the QE program is stopped and the central banks have cut their balance sheets again, it does not necessarily mean that the interest rate will keep on rising. For example, an increase in the velocity of money in the system would counteract the pressure on interest rates and could even make rates fall again. But if discontinuation of the QE-program is associated with an increase in inflation (and inflation expectations keep rising), then interest rates will probably continue to rise.

The development of interest rates is like the course of a supertanker

One should not expect interest rates to continue to rise for years in a straight line. The development of interest rates is as the momentum of a supertanker. It takes a long time before you have reversed the direction of a supertanker. One must therefore first expect the development of a large bottom pattern. And to this end it is interesting to look at US yields.

The 10-year yields in the $-sphere; long term trend

BLOG 20170224 FIG2 RENTE$
Figure 2.

Figure 2 shows two graphs on a monthly basis. The black graph, in the top, shows the development of the 10-year yield on US government bonds. And the blue graph at the bottom is the development of the 30-year yield on US Treasuries (CBOE). Line A, the red horizontal line in both graphs, is the most important line for the moment. It shows a considerable resistance, which has not yet been broken in both cases. This resistance coincides with the peak rate in 2015. It could well be that interest rates will go down again from this first level of resistance towards the bottom that was reached in both cases at the end of 2014. If this scenario manifests itself, we assume that the decline will take some time. This is a monthly chart; it can take several months before the fall has materialized. But we opt for a second, more likely scenario and that is that the current respite in the course of the next few weeks will be terminated with an outbreak upwards, with the interest rates rising to line B, the green horizontal line(s) in the figure. But then the supertanker again comes around the corner. From that level a sharp decline in interest rates is quite conceivable, back to the lows of 2012. Remember that Ms. Yellen is to be replaced by the end of this year!

Macro-economic reasoning

It’s speculation, but a reasonable macroeconomic scenario, which would explain our most likely scenario, is the idea that the Trump-administration will for a while keep-up the optimistic note of markets in general, but that in due course the chaos surrounding the Trump-administration will start to disappointment investors and will ultimately lead to an economic downturn or even a new recession.

Conclusion

Our first conclusion is that the supertanker is turning. Interest rates will ultimately turn the structural down trend into a long term uptrend in coming years, albeit in fits and starts.

Next week

And thus the next question is, how a bond investor can arm himself against an environment of structurally rising interest rates? The piece, that you have just read, is our introduction to this quest. Next week we will discuss some bond funds, asking ourselves whether they are or are not able to take advantage of rising interest rates.

The Hague, 24 February 2017
Gijsbrecht K. van Dommelen
Vladeracken Vermogensbeheer

www.vladeracken.nl

Disclaimer
The author is responsible for the investment policy at Vladeracken BV, an asset management company licensed by the AFM. Vladeracken invests and / or has invested in the securities discussed herein on behalf of its clients. This piece is not an investment advice. Whoever invests in the securities discussed herein and in accordance with the methodology and arguments discussed, or wants to invest accordingly does for his or her own accountability and risk. In this context, the author and Vladeracken BV disclaim all responsibility for the contents of this article. The securities and methods discussed represent a high risk.

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