Protection when the curve is flat
admin | September 14, 2018
This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.
The best time to buy insurance, or snow tires, or a home security system is before you need it. Laddering one-time callable debt into a portfolio with six months to two years of lockout provides a pick-up in yield over matched-duration bullets while the FOMC is still tightening, and hopefully results in duration extension before the cycle eventually turns.
A flattening curve begets falling volatility
The investment environment looks familiar because we’ve been here before. Many times, actually, but most recently in 2004-2006. Thirteen years ago the FOMC was approximately two-thirds through a stair-step hiking cycle. The fed funds rate increased from a trough of 1.00% in June 2004, to a peak of 5.25% in June 2006, in well-telegraphed 25 bp increments. Snapshots of the Treasury yield curve are depicted in the graph below: in September 2005 when the fed funds rate was 3.25%; eight meetings later it was 5.25%; and last week.
Exhibit 1: Treasury yield curves during last hiking regime and today
Our current cycle began with a fed funds rate at zero and somewhat lower long term rates. The transition from a steep curve at the trough through the gradual flattening of the curve towards the peak of the business cycle has been neatly mechanical to date. Higher rates and a flattening curve typically portend a lower, flatter volatility surface as well, and so far this cycle is no exception. Exhibit 2 shows the volatility curve for the 5-year tenor by option expiry for the same points in time. The curves across all of the tenors look very similar, with most having peak volatility in the 2-year to 3-year options. The Black volatility (quoted in percent per year) is higher now than it was in September 2005, but that’s predominantly because rates are lower.
Exhibit 2: Volatility term structure for 5-year tenor
A comparison of historical normalized volatility with Black volatility for the 1-year option on the 5-year tenor (1y x 5y) is shown in Exhibit 3. The red line is Black volatility, and the blue line is normalized volatility (in basis points per year) since May 2005. The predictable 2004-06 hiking cycle and the slowly flattening curve pushed volatility to then-historic lows. On a normalized basis volatility is back to those levels now, and it’s likely that Black volatility will decline further, and the volatility term structure flatten along with the yield curve, as the Fed continues to raise rates.
Exhibit 3: Black and normalized volatility over time
Layering in protection with callable debt
The timing for the next down cycle is obviously unknown, but we base our recommendations on the following assumptions:
- The economy will continue to grow, and the Fed will hike interest rates for another 6 to 18 months.
- Expected inflation in the long run is unlikely to materially exceed the Fed’s 2.0% target, keeping the long-end of the yield curve relatively anchored.
- The curve should flatten in the neighborhood of where the FOMC pauses, which we expect will be 3.00% to 3.50%.
- Volatility will continue to nudge lower and the volatility surface will flatten along with rates.
One method for protecting a fixed income portfolio for the eventual downturn is to start incorporating callable debt with one-time call options on longer maturities, with the expectation that the call will expire before the business cycle turns and rates begin to fall. For example, a 7nc1 1x has a coupon of about 3.26% – a pick-up of 35 bp over the 7-year Treasury – and duration of 2.6 years. Assuming that rates continue to rise, the duration will gradually extend, and the bond will likely trade at a modest discount over the next year. Ideally the option will expire with the Treasury yield curve flat at ~3.25%, and the callable becomes a six-year bullet before the next easing cycle starts.
The best pick-up in one-time callables versus similar duration agency bullets is for 7-year and longer maturities with 1-year to 2-year lockouts, as shown in Exhibit 4. The pick-up over matched-maturity agency bullets (not shown) is in the mid to high single digits for most structures.
Exhibit 4: Agency callable structures for downside protection
Risks and return
Callables tend to outperform similar duration agency bullets when rates remain fairly range-bound. The additional coupon earned versus matched-duration bullets increases their total return, as long as rates do rise too high and duration extends, or fall too far and the duration shrinks as the call option is more likely to be exercised. Not surprisingly, mortgages outperform in the same kinds of interest rate scenarios, which keeps the duration fairly stable.
Though it seems improbable, rates could rise higher than expected and the curve could significantly re-steepen – perhaps triggered by escalating inflation. Then the call options expire, the bonds fully extend, and you have a longer duration portfolio exactly when you don’t want it.
A less risky but perhaps more likely scenario: if the yield curve flattens in the neighborhood of 3.00% and stays there until the options expire, these bonds could be called away purely due to a decline in volatility cheapening the value of the option. In a flat yield curve environment that is a modest risk, as you could reinvest in a similar structure probably giving up only a few basis points.