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AAM Viewpoints – Inflation and Bond Duration


Bond yields are close to all-time lows across the yield curve, current inflation rates appear not to be an issue, and the Fed has stated they will not raise rates until 2023. The majority believe that interest rates will stay low for the foreseeable future; however, there are two sides to every market and although some might be in the minority, there are those who will take the flip side of this discussion.

First, there is nothing that says the Fed can’t change its stance at any time; there are no guarantees that they will keep rates low for the next two or three years. Interest rates in the intermediate and longer end of the curve can respond to fundamental changes in the economy or trading environment. It is accurate that the Fed can purchase longer-dated bonds – which they have done – supplying liquidity and a backstop to the markets which have held rates down on the longer end; and yes, they have unlimited resources to do that, but that has issues that could affect the market which will be left to others to evaluate and address. That said, from an interest rate perspective, it can be argued the Fed interest rate actions control the front end of the interest rate market.

There are many indicators one can reference when discussing what can cause inflation. There are a couple factors that have come about recently as a result of reactions to the business environment created by the pandemic. These couple factors arguably can contribute to inflation growth and possible rising interest rates. The first, and very significant factor, is the dramatic rise in Money Supply. A very basic economic fundamental is, if there is more money chasing the same amount of goods, prices tend to rise. There is an unprecedented amount of liquidity in the system from the recent stimulus packages, illustrated in the chart below.


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The second, not so traditional factor, is the overseas supply chains moving back into the U.S. for national economic security. This issue was highlighted recently when the supply chains of certain imports – such as pharmaceuticals – were at risk for various reasons. The same threats of supply-chain disruptions rippled through most manufacturing industries. What was a more cost effective way of running the economy, just in time inventories, and lower cost imports put our economy at risk during the pandemic. Many argue that moving manufacturing back to the U.S. will raise labor costs on many items, thus an overall rise in the cost of the goods. For those industries that cannot – or choose not to – move their manufacturing back to the U.S. may have to increase inventory levels of imported goods to assure that in the case of a future disruption in the supply chains they can keep their operations functioning. It is pointed out that this would increase the cost of goods from the sheer carrying costs and the physical storing of inventories. Both a rise in the costs of goods from U.S. manufacturing and rise in the expenses for inventory on hand could be argued to be inflationary.

Assuming for this discussion that inflation does kick in earlier than anticipated, what will that do to fixed income investments whether individual bonds or various 40 Act bond investments (Investment Company Act of 1940)? The simple answer is the market value of the fixed income investments will decrease. For those who are wary of inflation sooner rather than later, there are fixed income bond structures that can help “soften” the impact on bond values in case interest rates move up.

One way to potentially control risk is addressing duration risk. One definition of duration is: “A calculation that portrays to the bond holder when their initial investment is returned in the form of all interest and principal cash flows.” The lower the duration, the less impact a change in interest rates has on the market value of a bond; the longer the duration, the greater impact changes in interest rates have on the market value. As interest rates rise, bond values go down; as interest rates drop, bond values go up.

Currently, the 10-year Treasury bond is yielding around a 0.67%. If interest rates were to rise to where they were at the beginning of this year that would be an increase of 120 bps (basis point) as the yield on the 10-year Treasury was a 1.87% on 1/1/2020. Sounds like a lot, but we are talking nine months ago and, for reference, the yield on the 10-year Treasury one year ago was a 2.40%; and at the turn of the century was approximately a 6.75%, so going back nine months does not seem extraordinary. For illustration purposes and to simplify, we will use round numbers for calculation results, yields and maturity dates. For the interest rate move we will round down from 120 bps to 100 bps, or 1%. The idea is to show the impact of interest rate changes on different durations.

For investors who are cautious about interest rate moves, there are various bond structures that are designed to lessen the impact of interest rate changes. We will look at three different hypothetical structures each with a maturity of 10 years.

  1. The first is a lower market rate coupon, 1.50%, 10-year maturity with a yield to maturity of 1.50% priced at par or $1,000. This structure has the longest duration.
  2. The second example has a larger coupon, 5%, 10-year maturity with a yield to maturity of 1.50% priced at $132. This structure returns to the investor the initial investment sooner that the first example through larger coupon payments thus generating a shorter duration.
  3. The third structure is a callable or “cushion” bond where there is a large coupon, 5%, maturity of 10 years but has an optional call by the issuer at five years at 100 or $1,000.

The price of the bond is calculated to shorter call date, lowest yield to the investor, worst case scenario, in case the issuer exercises the call provision and retires the bond early. The yield to maturity is typically higher than the first two structures. This duration is the shortest as the call feature is used as the worst-case scenario regarding the return of the initial investment to the investor.

 

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Source: AAM | Data used for illustrative purposes only.

As illustrated, the higher the coupon, the lower the duration and the less impact a rise in interest rates have on the bond value. The third example of a callable or “cushion” bond is impacted the least by interest rate movements, however, there are a couple important points that could be a negative with this investment. First, if the issuer exercises their rights to call the bond on the call date in five years, in our example, the yield received would be 0.75% vs. the 1.50% in the first two examples. If the Example 3 bond does not get called early, then the investment pays 2.60% to maturity vs. the 1.50% in the first two examples. The second point is if interest rates rise so much that the price of the bond is a discount to par, or $1,000, then the “cushion” of calculating the price to the call date disappears and the price calculation is to maturity which is a longer duration much like the first two examples.

Your views on inflation and interest rates will likely give direction to your strategy. As always, there are two sides to every story.

CRN: 2020-0908-8561 R


This commentary is for informational purposes only. All investments are subject to risk and past performance is no guarantee of future results. Please see the Disclosures webpage for additional risk information at commentary-disclosures. For additional commentary or financial resources, please visit www.aamlive.com.

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