In early June, we presented a Goldman analysis which calculated what the market impact on fixed income securities would be as a result of even a modest 1% move higher in interest rates. The conclusion: a rather staggering $2.4 trillion in MTM losses for just US securities.
As Goldman explained at the time, “the aggregate interest rate duration across the bond market has also increased over the past several years, up over 20% vs. the 1995-2005 average level. Longer durations are largely driven by lengthening maturities on the bonds outstanding, as issuers have elected to term out their debt structures. Exhibit 4 shows that the average maturity of corporate bonds issued in 2015 and 2016 is over 16 years, vs. an average of 8.6 years during 1995-2005. The US Treasury has also chosen to lengthen its debt maturity structure, with more use of long duration bonds…. In 1994, the average yield on the bond index was 5.6%, vs. 2.2% currently. Lower bond coupons means that proportionately more of the bond cashflows now comes from principal, which tends to be distributed towards the end of the bond lifetime.”
Goldman further noted that “the total face value of all US bonds, including Treasuries, Federal agency debt, mortgages, corporates, municipals and ABS, is $40 trillion (Securities Industry and Financial Markets Association).”
Doing the math, and combining an aggregate duration estimate of 5.6 years with the SIFMA total estimated notional exposure of $40trn, and current Dollar price of bonds of $105.6, indicates that, to first order, a 100bp shock to interest rates would translate into a market value loss estimate would be $2.4 trillion.
This duration impact from 1% changes in rates was also shown schematically one month later by JPMorgan, which showed the convex impact on bond duration from a 1% parallel shift higher in interest rates as follows:
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But what about the impact on equities from rising rates?
Last week, GMO’s Ben Inker decided to analyze precisely this in a note titled “The Duration Connection.” This is what he found in terms of portfolio implications, and specifically equity exposure:
In general, there has not been a particularly apparent rush into long-duration fixed income despite the strong returns, because the simple math of bonds is such that most investors realize intuitively that falling bond yields are a negative for future returns. But there has been continued enthusiasm for strategies that have the same effect – notably risk parity variations – because they allow investors to think that, despite the massive holdings of bonds in these portfolios, they are “balanced” and reasonably safe even against scenarios that involve rising rates.
But the trouble with returns that come from falling discount rates is that they represent an increase in the present value of the asset without any increase to the cash flows to the asset class. The future expected return to the asset has fallen, and in a way that more or less precisely counteracts the increase in current value. In other words, the present value of the assets has risen but the future value of the assets has not. Nowhere is this clearer than for the purest long-duration asset in existence, the zero coupon bond. Let’s say that you will need, with absolute certainty, $1 million in 2026. The safest way to reach that goal is to buy a $1 million face value 10-year zero coupon Treasury bond maturing in 2026. Such a bond currently has a yield of 1.625%, which means it will cost you $851,127 to buy it today. Assume that tomorrow the yield falls by 1% to 0.625%. Your brokerage statement will declare the value of your bond to be $939,596, a gain of over $88,000. Whoopee! You’ve just made over half of the necessary return over the next 10 years in a single day. But the value of that bond in 2026 has not changed at all. It has a fixed maturity value of $1 million. The only thing that has changed is the discount rate being applied to that cash flow, not the cash flow itself. Assuming you still need $1 million in 2026, there is no windfall to spend. Economically, nothing has changed for you, whatever your brokerage statement says.
This is the nature of the discount-rate-driven gains for asset classes such as equities, bonds, and real estate. Beyond the discount rate change, it is still true that US equities have done surprisingly well, emerging equities surprisingly badly, and so on. But even if those “surprises” are permanent (and our guess is that for the most part they are not) the fact that the valuation of US equities has risen guarantees that the future returns to US equities from here will be lower than they would have been otherwise, and the same is true for all of the long-duration assets whose discount rates have fallen over the period.
The most shocking hole that will be blown through people’s portfolios is if discount rates rise again fairly quickly. Even if the circumstance is one in which the global economy is doing well, the impact of a 1.5% increase in the discount rate on equities from here is a fall of over 30%, which would almost certainly be enough to swamp the earnings impact of the decent growth. For bonds, of course, there would be no possible counter to the discount rate effect. For a portfolio that is fully invested in long-duration assets (i.e., consists of a combination of stocks, bonds, real estate, and private equity), the possible performance implication is on the order of the falls experienced in the financial crisis – perhaps a 20-33% fall depending on the weightings – despite the fact that the global economy was doing just fine.
Inker’s conclusion:
The unwelcome truth is that there is not a tremendous amount investors can do about the fall in prospective returns. If the shift is permanent – the “Hell” scenario we’ve written of before – returns will be lower to all assets for which the discount rate has fallen, but at least the windfall gains will have to be repaid only very slowly. If the shift is temporary, we will wind up giving back the windfalls of the last six to seven years. The temporary shift scenario is better for investors in the long run, but it would be massively painful in the interim, because it will affect almost every asset in most investors’ portfolios.
There is no panacea for the low returns implied by asset valuations today. Anyone suggesting differently is either fooling themselves or trying to fool you. But piling into the assets that have been the biggest help to portfolios over the past several years, as tempting as it may be, is probably an even worse idea than it usually is.
And yet piling into what has worked, is precisely what the Pavlovian market has been trained to do in hopes
In early June, when we showed the $2.4 trillion in MTM losses from a 100 bps move, we titled the post “Why The Fed Is Trapped.” Inker’s analysis confirms this: should the market perceive the jump in rates as a permanent phenomenon – something which helicopter money would quickly achieve – the “possible performance implication is on the order of the falls experienced in the financial crisis – perhaps a 20-33% fall depending on the weightings – despite the fact that the global economy was doing just fine.”
We are confident that the Fed is quite aware of this adverse impact to its price stability mandate, even if it wasn’t when it first started hiking rates as “proof” of just how strong the economy was in the fourth quarter of 2015… which as we now know grew at a just a 0.8% annualized rate, the lowest in two years.
And just in case Yellen has forgotten about “discounting” – the most fundamental concept of finance – which is understandable in this day and age of zero, or negative, interest rates everywhere, we urge her to skim Inker’s paper “the Duration Connect.” She may not like what she reads.
The post Ben Inker: This Is The “Shocking Hole” That Will Be Blown In Equities If Rates Spike By 1.5% appeared first on crude-oil.top.