Here's what the OFR didn't say about bond funds' reach for yield

by 21 Dec 2015
Investor exposure to interest rate risk remains historically high, making investment positions susceptible to greater losses in the event of large interest rate increases. Such increases could be caused by surprises in the Federal Reserve’s normalization of monetary policy — expected to be carried out over the next several years — or other shocks. The Federal Reserve itself faces challenges in normalizing monetary policy. And several factors are keeping interest rates well below past norms. If these factors changed suddenly, an interest rate shock or the inability of the Federal Reserve to normalize policy as desired could threaten financial stability. The duration of investors’ U.S. bond portfolios remains at historic highs, increasing their exposure to interest rate risk. (Duration measures the sensitivity of bond prices to changes in interest rates; broad investor duration in the figure is proxied by the duration of the Barclays U.S. Aggregate Bond Index). Broad investor duration has increased because investors are reaching for yield and the low interest rate environment has encouraged debt issuers to extend the term of their debt.

All very true, and worthy of revisiting given that the market remains dismissive of the pace of interest rate rises implied by the Federal Reserve's newly released dot plot. By the OFR's estimates, the $3.8 trillion worth of U.S. bond mutual funds and ETFs would face an unhedged loss of $214 billion, or 5.6 percent, in the face of a 100 basis point increase in interest rates. Those are big numbers, to put it mildly.

But those figures get murkier once one peeks into the technicalities of the benchmark that such bond funds are seeking to beat, in this case the Barclays U.S. Aggregate Bond Index, affectionately known as the Agg (Disclosure: Bloomberg recently announced a deal to purchase this bond index, and many others, from Barclays). The problem comes about thanks to the Federal Reserve's bond buying program, which has seen the central bank snap up billions of dollars worth of U.S. Treasuries and mortgage-backed securities (MBS) guaranteed by the government.

While the Barclays Agg strips out Fed purchases of U.S. Treasuries from its index, it doesn't do the same for MBS, a situation which has been the source of much griping for asset managers seeking to match the returns/duration of the benchmark. Since MBS boast longer duration than many other types of debt, it becomes much, much harder for bond fund managers to add duration to their portfolios given that the central bank has essentially squirreled away a huge chunk of the MBS market - and the precious duration that comes with it - on its balance sheet.

In some respects this is an intended consequence of the Fed's quantitative easing; push up demand for MBS and thereby lower mortgage rates, while simultaneously encouraging investors to move out of their comfort zones and into riskier, higher yielding assets. Yet, as the OFR report implies, if bond fund managers  have not given up on duration despite the difficulty of matching an index when the MBS cupboards are fairly bare (or at least more expensive), the question becomes from just where where they are getting that duration?

Anecdotal evidence suggests long-dated corporate bonds, but even here demand has often outpaced supply, leaving some investors scrambling for derivatives and repo deals to create a synthetic form of duration (and a form that comes with extra leverage, thrown in to boot).  In fact, the International Monetary Fund, in a blog post today, warned that derivatives leverage in bond funds has largely been masked by years of low volatility and interest rates.

If one takes some literary liberties and assumes duration is synonymous for the reach for yield, then it seems we still don't know exactly what bond funds have been pulling down from the shelves.

Bloomberg News
Tracy Alloway and Joe Weisenthal


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