2013 Scenario: Musical Chairs Will Cost Negatively-Convex Investors

The Tradex Group Weekly Blog

February 25, 2013

By Michael Beattie, Chief Investment Officer

2013 Scenario: Musical Chairs Will Cost Negatively-Convex Investors

What’s coming down the pike on interest rates and negatively convex investments?

It’s a fair - and relevant – question, given the fact that many investors are negatively convex in a big way, and thus exposed if interest rates rise.

Thanks to automatic $1.2 trillion budget cuts in the federal budget on March 1^st (political types call those cuts a “sequester”), investors are still getting out of equities and putting more assets into bonds.  According to Citigroup, bond fund inflows for the second week of February totaled $2.6 billion, compared to $1.8 billion for equities.

No doubt, those investors are in search of safe harbor investments, and are expressing some anxiety over the volatility of the stock market and are growing increasingly skittish about the U.S. economy.

But be careful what you wish for…  Fixed income investors may not be accounting for interest rate risk.  Currently, the federal funds target rate stands between 0% and 0.25% — historic lows by any measure.  If inflationary pressures begin to swell, interest rates have nowhere to go but up.  The question isn’t if rates will rise, but when.

Make no mistake, if rates rise (as will inflation), those fixed income investors will lose money.  When investors are long credit, they have negative convexity if rates spike upward.  Most investors hold these negatively convex securities right now, such as corporate high-yield bonds and exchange traded funds that earn some (small) yields in their portfolios.

That investment path, to a point, is understandable.  Investors aren’t getting much yield from Treasuries, where the 10-year bond is returning a measly 1.98%, as of February 24, 2013.  Yet reaching out for longer-term bonds and bond ETFs has left fixed income investors exposed, and at significant risk.

Call it a dangerous game of musical chairs.  When the music stops, and interest rates rise, some of these investors will be left without a chair.  That could prove to have a catastrophic impact on client portfolios, especially since investors in many cases really aren’t earning more than 5%, making the convexity a big “risk versus reward” issue.

What to do to get out of the negative convexity trap?  We recommend turning to positively convex securities, such as agency interest-only (I/O) mortgage derivatives where the asset value rises when interest rates rise, or to be outright short high-yield bonds where prices are expensive and risks of interest rates rising and further destroying value are large.

As stated above, since rates have already hit near ‘rock-bottom’, there’s really nowhere to go for them but up.  And that’s where mortgage IO derivatives and short expensive high-yield bonds can protect investor’s portfolios, providing strong returns even as rates rise.

Consider that strategy before rates rise, and insulate the fixed-income portion of your investment portfolio from collateral damage due to negative convexity.