March 18, 2014 11:00 am

Hunger for long-term debt poses US rate risk

Will it be all pain and no gain for investors who have piled into long-term corporate debt recently?

Despite rising expectations of higher US bond yields this year, and the falling bond prices that are the flip side of that coin, there has been no shortage of buyers for the 30-year dollar bonds sold in recent weeks by companies such as Bank of America, General Electric, Pemex, Novartis, and JPMorgan Chase, among others.

Corporate bond debt

Corporate bond debt
Top 2014 sales, US and global aggregates

Such bonds could suffer big price falls if interest rates rise in the coming months. The danger was amply and dramatically illustrated last year when Apple’s 30-year bond quickly lost nearly a fifth of its value as Treasury yields rose sharply during the summer.

Long-dated bonds are noted for being more sensitive to changes in underlying interest rates than shorter-term debt securities.

For now, scepticism about the health of the US economy, low inflation and the expectation that the Federal Reserve is in no hurry to tighten monetary policy, as it slowly tapers its monthly bond purchases, have placed a ceiling on long-term interest rates.

Rather than question whether this can last, investors have been willing buyers of long-term bonds, or those with a maturity of greater than 10 years.

“The lesson here is that it has become extremely difficult to time the bond markets,” says Robert Tipp, chief investment strategist at Prudential Fixed Income.

“Even with a benign economic scenario and indications the Fed would start to taper, rates did not back up sharply, and probably won’t in the near future. As a result, long-term fixed income will outperform cash.”

Concern about duration exposure in bond portfolios is being downplayed for the moment. Long-term corporate debt has generated a total return of nearly 5 per cent so far this year, while junk bonds have returned 2.4 per cent, according to Barclays.

That is good news for institutional investors, such as pension funds and insurers, which have been the biggest buyers of long-term corporate debt in recent months. They use high-grade, longer-dated bonds to match their underlying liabilities, but a turn higher in rates stands to hurt those investors chasing the higher yields on longer-dated debt.

Jay Mueller, portfolio manager at Wells Capital Management, says the appetite for duration exposure is data-dependent. Pension plans, which have been switching out of equities after their strong performance in 2013, are now moving into the longer-duration trade as uncertainty over the strength of the economy and low inflation dominate sentiment.

“The preferred mechanism for pension plans immunising their portfolios is buying long-dated credit,” he says. “We seem to be in one of those periods where there is scepticism about the strength of the US economy, and yet the Fed is winding down its large asset purchase programme.”

With the Fed’s taper on course to end by September, and the economy expected to rebound from its winter blues, the clock is ticking for long-term interest rates.

A robust pick-up in economic activity that vindicates the recent record US equity market run is seen pushing long-term interest rates much higher.

The yield on 10-year US Treasury bonds stands at 2.67 per cent, but many economists forecast an increase to 3.5 per cent by the end of the year. As a rule of thumb, a bond with a duration of 10 years would experience a price decline of 10 per cent in the event that benchmark interest rates rose 1 percentage point.

“At this stage, I’m not sure I would go too much beyond the 10-year mark when it comes to duration,” says Jim Sarni, a managing principal at Payden & Rygel.

“There’s a yield pick-up the further along you go out with the [maturity of] bonds, but I don’t think it’s worth it, given the potential for price declines were benchmark rates to back up quickly,” he adds.

For now, companies have been taking advantage of changing investor sentiment and the strong demand from institutional investors, with issuance of long-dated corporate debt at a robust level of $126bn so far this year, according to Dealogic. That figure is running slightly below last year’s record pace of $145bn, for the same period.

“Demand from pension funds and institutional investors has been pretty powerful,” says Mr Sarni. “But it makes you wonder how long will it last, and what kind of impact it may have if for some reason they become less supportive.”

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