Having talked about cash, let’s now add negative rates to the calculus an investor must perform.
With a positive rate, we can compute the sensitivity of a bond’s price to a change in an interest rate. The technical term is duration. The rate of change in duration is called convexity. Books have been written on these two items and the technical ways to calculate them and use them.
We will purposefully simplify. An elementary lesson in duration will tell the student that a zero-coupon, riskless sovereign instrument has a duration that matches its maturity. For example, a one-year US Treasury bill has a duration of 1. A 30-year US Treasury STRIP has a duration of 30.
In the first case, an interest-rate change of 1% will move the price by 1%. In the second case the same 1% change in interest rates will move the price by 30%. Now, actual calculations will yield a more accurate number, so I’m asking my professional readers to indulge this simplistic definition and not email me about semiannual compounding and convexity and transaction costs and other requirements. We know they are there. In our shop we compute them daily. For general readers, however, let’s keep this simple and straightforward.
What happens when the instrument is issued at a negative rate, as is the present case with the benchmark 10-year German government bond, denominated in euros? That bond has a final maturity of 10 years. Its market based interest rate is below zero on issuance. It is a zero-coupon bond issued above the par. It pays no interest during the 10 years. The buyer puts up money and gets less money back at maturity ten years later.
So what is the duration? What method should we use to estimate the price sensitivity of this bond?
Here is where the calculation gets difficult. Conventional bond analytics do not yield an answer. They know only how to end at maturity.
So to get to a true duration, the investor has to add an assumed reinvestment risk rate that is positive and start that as an earnings rate 10 years from now. In other words, what will the money yield 10 years from now when the initial maturity occurs?
Of course, we don’t know. So we plug in some numbers. In our case studies we have used 1%, 2%, 3%, etc., to run scenarios. We get estimates based on what it would take to get the investor back to zero. Our view is that the full recovery of the negative rate makes one “whole,” and therefore the investor is back in the same position as if he or she were buying a zero-rate STRIP of a bullet maturity.
When we do this exercise, we find the duration estimate for the negative-rate issue to be a large number. Thus we have a way to estimate the risk attached to it.
Factor into this calculation the notion that all asset classes are being impacted by the spreads among the various types of investments that are the alternatives to the negative-rate benchmark. We can infer that duration of all instruments is rising due to the influence of the negative rate. And we can infer that duration is rising robustly in response to the fact that almost 13 trillion US dollar equivalent is now trading at negative rates in this crazy financial world.
In sum, duration warns you about risk. It has no value with regard to timing. Risk can rise for a long time or until tomorrow. The real question for an investor is simple: Am I getting paid enough for the risk I am taking?”
In this high-duration world, we think the answer is often 'NO!' So at Cumberland, action is now required.
At Cumberland, we have raised some cash in our US ETF accounts. And we have shortened duration where we can in our managed bond accounts. Risk is rising. We manage risk for our clients. And when risk is rising, prompt action is imperative.