No Free Lunch

We’d like to talk a little about interest rates and bond markets in this article.  The topic is misunderstood by many and can be very complicated, but there are some truisms that can never be ignored.  They are;

1. Bond prices move inversely to interest rates. e. if interest rates go down, bond prices will go up.  And visa-verse.
2. Of the many types of risk in bonds, two are dominant;
   1. Credit risk; the likelihood of getting paid back by the borrower. High yield corporate bonds are riskier than Treasuries.
   2. Term risk; the ‘compensation pay-off’ for taking longer term bonds vs. shorter maturity ones. Longer term bonds SHOULD reflect higher rates to compensate for the additional risk lenders (you) take on.
3. If you add leverage to bond bets (borrowing more money to boost returns), just know that that knife cuts both ways. Sometimes you get bigger returns, sometimes you get bigger loses.
4. No one –repeat, no one – knows when interest rates will change and by how much.
5. When one person is getting a ‘good deal’ with a low interest rate, someone else is getting a less good deal by lending more cheaply than they perhaps should have done.  What is good for the goose, is not necessarily good for the gander.

Added to those five facts, we must factor into the equation that we are in / have been in the lowest interest rate environment this country has had for 60-80 years.  When you have a concerted government effort to push interest rates down (Quantitative Easing), and then keep them down, you have both positive and negative effects.  Having low interest rates for borrowers is NOT always positive for everyone…said succinctly, there is no such thing as a ‘free lunch’.

Finally, over the past 2-3 months interest rates have begun to creep up.  The comments from Federal Reserve Chairman this past week only spurred the inevitable, and when he said the federal government might have to stop the efforts to suppress interest rates (whose intent was to help revive the economy), the capital markets reacted.  Sure, we can argue that they over-reacted, but markets always over-react in the short term.  The bond market, in particular, is in turmoil with interest rates jumping 1% or so.  Though all fixed income funds would be hurt in this environment, the ones really getting hurt are those folks who went for the “free lunch” (better returns with no significant additional risk);

1. Those seeking high yield bonds saw declines of 5% over just the last two weeks alone[i] (and right on cue, May 2013 investor inflows hit a lofty $43,500,000,000!!)[ii]
2. Funds that promised protection for investors by using ‘risk parity’ to get steady smooth returns (too complicated to explain here, but you have admit it really sounds good), also lost 4-7% so far this year (part of the two-way sword nick to the portfolio skin referred to in item #3 above)[iii]
3. Long-term bonds are those with durations of 7-30 years. On average, duration is the measure used to define how sensitive bonds are to interest moves.  A 10 year duration bond will go down 10% for every 1% change upward in interest rates.  Meaning; you don’t want to go long when interest rates have nowhere to go but up.

Now, from our side, the only thing we would say on interest rates is we’re simply “reverting to the mean”.  Keeping it all very simple and yet containing 80% of the story, the punch line is why would you lend to someone for 2% when you know inflation is going to be 3%?  There are a lot of fancy terms used by people trying to sound really smart, but it’s really not that hard.

Investing well and wisely is learning to be disciplined and not always follow the crowd.  You certainly do have fixed income investments at Wellspring but;

1. NONE of them are high-yield
2. You have NO long-term bonds
3. Your portfolio holds north of 1,000 bonds so your diversification is beyond comparison
4. For the 12 months ended June 30, 2013, the four main fixed income funds utilized have All had a positive return[iv]

Now you know ‘the rest of the story’.  As it has been true since the times of Mesopotamia, there is no such thing as a free lunch.

[i] “High Yield Bleeding Slows, But Is There Anything Left To Drain Out” (Market Realist, June 24, 2013)

[ii] “High Yield Bond Volume Hits Impressive $43.5 B in May” (Forbes, Market Research and Analysis, Tim Cross contributor, June 5, 2013)

[iii] “Fashionable Funds Hit Hard” (Wall Street Journal, Investment section, June 28, 2013)

[iv] Fund Center; Performance (Dimension Fund Advisors website, July 2013)