The long grind lower in US Treasury interest rates continues in 2015. In this post we will have a look at where the interest rate market has been and what the implications might be going forward when incorporating a fixed income allocation to a portfolio.
Portfolio Workstation has a data connector for FRED that allows us to overlay data published by the St. Louis Federal Reserve Economic Data (FRED). We will use this feature to overlay interest rates on mutual fund performance charts to help with this study. Adding the overly is as simple as checking the desired box, as pictured here:
The following image shows VUSTX, the Vanguard Long Term Treasury Inv Fund with the 10 year yield overlayed. This mutual fund has been around since the mid 1980’s, so it makes a great illustration of the gains that could have been had by investing in treasuries over a long period of time. The green line is the VUSTX performance line, with the split and dividend adjusted price on the right side. The blue line is the 10 year US Treasury interest rate as published by St. Louis Federal Reserve Economic Data (FRED).
This picture does a good job illustrating the long bull market in treasuries, although it doesn’t quite go all the way back to the beginning when long rates peaked at about 15% during the Volcker era. Interestingly, the largest drawdown for VUSTX holders since inception was 18.4%, and the compound annual growth rate (CAGR) was 8.3%. If that CAGR seems higher than where it should be given the average level of interest rates during that period, you’re thinking clearly. The average interest rate was approximately 5.5%.
Under the surface, there’s an awful lot going on here. One factor is that VUSTX carries treasuries at a variety of maturities out of necessity. Maintaining a target maturity duration as a lender is a aiming for a moving target. Over the course of this study, there had to have been a 100% turnover in the holdings of VUSTX, otherwise what used to be a long term fund would now be a short term fund, or more likely sitting on the cash from paid off loans. Because of pro-active rebalancing to maintain it’s long term charter, VUSTX very likely had an average maturity longer than 10 years over the course of this study, and by implication a slightly higher average interest rate than 5.5%.
Another important factor is that bonds purchased in a higher yield environment have a greater market value in the lower yield environment, which is what we see playing out over and over as rates grind lower. An exaggerated and oversimplified example should convey this concept so that we can move past it. Pretend you purchased for $100,000 a fixed income note yielding 10%, and the market for those notes moves to 5% yield the very next day. Your note is still kicking out the same fixed income coupons as before, so how is it a 5% note now? Because the market is bidding your note at $200,000 now ($10,000 of annual interest is 5% of $200,000). You can sell the note into the market and realize a huge capital gain, and by doing so you will have pulled future income to the present.
One of the purposes of this post is to call it out that there is a limit to this quality of the interest rate bull market. As rates go lower, there is less future profits to pull forward to the present. A zero yield bond is a loan with no risk premium. It is literally an IOU that only pays back principle, and as long as nothing goes wrong with the borrower. If bond yields get to zero, there is no profit incentive to be in the lending business.
Going back to the 8.3% CAGR that our model bond fund has, we can see that the lower nominal rates go, the more dependent on the “pull profits forward” effect it’s performance becomes, and at the same time, there is less future profits available for pulling forward because there is less profit from interest at lower yields.
This brings us to the 60% stocks, 40% bonds portfolio. This common portfolio allocation strategy relies quite a bit on bonds, and projecting the past into the future without regard to the impact of the changing nominal yield enviroment would be a setup for disappointment. Having said all that, let’s look at a long view of the past for the 60 / 40 portfolio using Vanguard’s S&P 500 fund VFINX at 60% and VUSTX at 40% and the 10 year yield overlay.
One final observation here is the rebalancing effect on stocks from bond funds in a falling yield environment. With so many investors maintaining fixed allocations between stocks and bonds, great performance in bonds has been a driver for higher stock prices. It is unlikely that the future will resemble the past in the bond market in the coming decades. The current generation of investors are accustomed to stock panics driving money into bond funds, but if this dynamic were to flip around, and panics in low yielding long term bond funds caused a rebalancing feedback driving stock prices lower, it would be a new era of rising interest rates.