Fixed Income Investing at the Zero Lower Bound–Throw Away Your Fucking Finance Textbook

There’s a hopelessly confusing mess of information – some grounded in fact, some appearing on Squawk Box and similar shows – about fixed income investing in today’s macro environment.  In this post, I’m not predicting the future or recommending any investment strategy, but instead explaining how and why some government securities did really well in 2014 even though pundits abound cursed them as a surefire way to lose money in 2014 .  And, I should add, said pundits weren’t really all that stupid in doing so, because an oversimplified analysis of the interest rate environment pre-2014 pointed in that direction.

Rates on the U.S. 10 year treasury went down in 2014, from about 3% to 2.17%, despite widespread predictions that monetary policy would inevitably cause rates to increase. If pundits everywhere predicted this, why did the opposite materialize?

Global growth slowed down in 2014, dragging inflation down with it. Greece had another…episode, which reintroduced the possibility of a ‘Grexit’, pushing rates down further. So, by 2014’s end, the 10 year treasury rate had decreased by about 75 basis points, moving in the opposite direction from rates on high-yield debt. In other words, credit spreads widened in 2014, meaning investors demanded more compensation in order to take on credit risk (i.e. lend to corporations via bonds).

Intuitively, widening credit spreads are the result of investors demanding more compensation in exchange for lending to corporations and other risky entities, because they perceive them to be increasingly susceptible to risk in comparison to the U.S. government. Why would this be the case? Usually because the economic outlook isn’t so good – investors fear corporations are less credit-worthy due to their prospects and demand to be compensated accordingly. Furthermore, investors tend to seek the safest securities during times like these – i.e. ‘flight to quality’ occurs – namely U.S. government securities, which pushes down rates. This increases the credit spread, pushing risk free rates further away from rates on other debt.

The scenario described above is why in 2014 the average return on the 10 yr. treasury was about 10% despite the consensus forecast that they would perform poorly. Remember, the price of a bond is inversely related to the rate of interest, which is why the widening credit spread and corresponding decrease in rates pushed up the value of 10 year treasuries held by investors. To see why, think about the discount factor associated with a 10 year treasury at 3.02% versus 2.17%. In the first case (i.e. at the beginning of 2014), a $1000 par value bond is worth $741. When the applicable rate of interest falls to 2.17%, however, the corresponding price is $805.87. Clearly, the value of the 10 year US treasuries was impacted favorably by the decrease in rates, benefitting the investors who held them throughout the year. Moral of the story: interest rates are fucked up and hard to predict, and Squawk Box is almost never right.

About schapshow

Math & Statistics graduate who likes gymnastics, 90s alternative music, and statistical modeling. View all posts by schapshow

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