Managing Long-Term Bonds

Managing Long-Term Bonds

Several weeks ago, I penned a note to members of EPB Macro Research discussing the volatility associated with long-term bonds, how we navigate the chop, and a few possible ways to play the ongoing slowdown in economic growth.

Before recapping some of the highlights of that members-only note, I thought it would be worthwhile to contextualize where we came from.

In late 2017, based on the trajectory of our most long leading economic indicators, it became clear that the US economy was going to have decelerating rates of growth in 2018. At the start of Q2 2018, the slowdown spread from long leading indicators to short leading indicators, providing more confidence in the forward outlook.

We were expressing this view through a position in long-term bonds (TLT) (EDV) as well as an overweight position in defensive equity sectors such as utilities.

Long-term bonds had an enormous move, rising nearly 50% from November 2018 through August 2019.

After the first round of interest rate volatility, at the end of September, in our[Portfolio Update]report, we reduced our exposure to long-term bonds by nearly 70% in response to the increase in volatility. This reduction in exposure occurred when TLT was roughly $143 or about 3% from the all-time closing high.

This reduction in exposure was not due to a lack of conviction in the economic outlook but rather a portfolio risk management system outlined in more detail inside EPB Macro Research.

Today's re-emergence of interest rate volatility comes with a lack of a material change in the growth/inflation fundamentals.

This presents a good opportunity to share part of the note from a few weeks ago addressing the volatility of long-term bonds and to manage expectations when engaging with volatile securities.

Long-term bonds (EDV) are very volatile instruments. It is important to understand the volatility associated with a security before making an investment so the position can be sized appropriately.

Let's take a look at a quick case study to understand the volatility associated with long-term bonds.

The last major bull market in long-term bonds occurred from 2014-2016 when the last global slowdown resulted in recession fears and some pockets of negative growth around the world. Also, a massive disinflationary wave, similar to today, pushed the US producer price index below -1% and the consumer price index to -0.24% at their respective low point.

30-Year Treasury Rate (%):

Source: Bloomberg, EPB Macro Research

This deceleration in the rate of growth and inflation resulted in a staggering 80% total return for ETF EDV from the start of 2014 through July of 2016.

It is easy to look back in hindsight and suggest that it would have been easy to hold this ETF through any amount of volatility in order to make nearly 80% in 1.5 years, a return profile virtually impossible in the broad stock market.

EDV Total Return Price: 2014-2016

Source: Bloomberg, EPB Macro Research

During this massive 1.5 year bull-run, EDV suffered a 24% pullback. There is no right or wrong answer, but it is worth asking the question as an investor as to whether a 25% decline would have been enough to cause questioning of the thesis, or "second-guessing." After the 25% pullback, EDV went on to rise another 38% to complete a nearly 80% move.

Is a 25% pullback too much to handle? If so, the position must be sized appropriately. If this volatility is just far too much, shorter duration bonds (IEF, IEI, SHY, SHV) may be more appropriate. Again, there is no right or wrong answer, but it is critical to have a deep understanding of the return profile associated with an investment.

From early 2017 through the present day, EDV has made another impressive rally, increasing nearly 28%.

In that time, during late 2018, EDV suffered a 15% drawdown before a stunning 48% rally in less than one year.

EDV Total Return Price: Today

Source: Bloomberg, EPB Macro Research

The recent pullback in EDV has been roughly 12%, less than half that of the 2015 decline, yet the former (2015) did not change the fundamental thesis, and ultimately, bonds made a new high at the conclusion of the growth rate cycle. Changing market narratives, sentiment, and monetary policy expectations can cause wild fluctuations in volatile securities.

The potential volatility should be well understood.

If the fundamentals of growth and inflation change, it makes sense to close positions in long-term bonds entirely and shift towards cyclical assets that will benefit from rising growth. If EDV declined another 10% from here yet the fundamentals did not change, how would you respond?

For those investors who have a long-term horizon, when assessing long-term bond yields, the only relevant question relates to growth and inflation. If growth and inflation have inflected higher, and this cyclical downturn is over, then long-term bond yields will rise and stay elevated until the next slowdown. In all likelihood, due to secular conditions, the rise in bond yields would be less dramatic and result in continued lower highs, a trend that has been in place for decades due to demographics and excess levels of unproductive debt.

If growth and inflation have not inflected higher, this move in bond yields will prove transitory, similar to 2015. A risk management process is likely needed to navigate elevated volatility.

The CRB index of raw industrial materials, a group of commodities that are not subject to speculation via futures contracts, sits virtually at the cyclical low, arguing against any sustained rise in inflation pressure.

CRB Index Raw Industrial Materials:

Source: Bloomberg, EPB Macro Research

Exchange-traded commodities, however, responding to each trade headline, have diverged from their non-exchange traded counterparts.

The CRB index of raw industrials does not trade intra-day and only prices overnight, a much cleaner read on true supply/demand for industrial materials compared to exchange-traded commodities such as copper.

Divergence: Exchange Traded vs. Non-Exchange Traded:

Source: Bloomberg, EPB Macro Research

In other words, similar to the stock market, euphoria and optimism have caused a rally in risk assets and speculative commodity prices while underlying price pressure for a basket of sensitive industrial commodities has not rallied even 1%.

It is worth noting that Treasury bond legend Lacy Hunt has not seen conditions that suggest long-term bond yields will stay elevated as growth and inflation both remain in a cyclical downturn.

The global over indebtedness has clearly restrained growth, and therefore has had a profound disinflationary impact on every major economic sector of the world. This fact, coupled with an overzealous U.S. Central Bank have created the conditions for an economic contraction in the U.S. and abroad. This has also created a worldwide decline in inflation and inflationary expectations. It is therefore unsurprising that record lows in long term interest rates have been established in all major economic regions. A quick and dramatic shift toward greater accommodation by the Fed could begin to shift momentum from contraction toward expansion. However, policy lags are long and slow to develop, therefore despite the remarkable decline in long term yields this year, we are maintaining our long duration holdings. A shift towards shorter duration portfolios would be appropriate when the forward-looking indicators of expansion, in the U.S. and abroad, begin to appear.

-Lacy Hunt | Hoisington Management

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Disclosure:

I am/we are long TLT, EDV.I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.