"Duration has never been this long in my career. With rates near the lowest levels ever and duration at literally the highest level ever, it is the worst possible setup [in] history. You are [taking] more risk and getting less reward."
— "bond god" Jeffrey Gundlach, CEO of DoubleLine Capital, on April 10 in Financial Times
Investors have been gobbling up record volumes of new corporate and emerging market debt this year. The Wall Street Journal reports emerging-market governments and foreign companies in those markets sold almost $200 billion worth of dollar-denominated debt through March. This was the strongest first quarter on record, according to market data firm Dealogic.
Here in the U.S., high-quality companies with "investment grade" ratings sold over $400 billion worth of new debt in the first three months of the year. This is an all-time record for any quarter. And junk-rated companies issued almost $100 billion of new debt, double the amount issued in the first quarter of last year.
Another way to look at this: Investors are piling back into bonds.
But the sheer volume of bond buying isn't the only record that has fallen of late. Bond market duration also has soared. Duration is a measure of how long it takes to recoup an investment in a bond as well as its sensitivity to interest rate movements.
Said simply: Duration is a measure of interest rate risk. Let's explore the current implications.
According to Wall Street Journal data, one-year U.S. Treasury bonds have an effective duration of 0.96 years. This means that one-year treasuries will fall about 0.96 percent in price for every 1 percentage point rise in interest rates.
Moving out a little longer, 10-year treasury notes have a duration of 9.2 years (representing a 9.2 percent decline for every percentage increase in interest rates).
30-year treasuries are even worse. These longer bonds have a duration of over 20 years, indicating investors are signing up for a 20 percent decline with every percentage point increase in interest rates.
For passive index funds tracking these benchmarks, a jolt higher in interest rates would be painful.
So why is this happening?
While the U.S. Federal Reserve hiked rates again in March, many money managers heard comments by Fed officials that the pace of future rate hikes would be moderate. This signal encouraged folks to load up on these longer-duration bonds.
But if the Fed is going to only gradually raise rates, why should we be worried?
First, few things ever go perfectly according to plan.
Second, while future hikes to short-term interest rates may be gradual, minutes from the latest Federal Reserve meeting indicate the Fed may begin to "unwind" its $4.5 trillion portfolio of treasury bonds and other debt.
Remember all that money printed over the last nine years through quantitative easing? That money got plowed into treasuries, which made them soar in price, which in turn lowered the yields and associated benchmark for market-wide interest rates.
Now the Fed is planning to stop reinvesting the cash from maturing bonds — mostly treasuries and mortgage debt — back into these markets. This would remove a significant source of demand for these bonds from bond markets.
This alone could send long-term interest rates higher. But this may be compounded by foreign investors changing behaviors too. This leads to the third consideration around the risk of duration.
While the Fed holds about $2.5 trillion of its $4.5 trillion portfolio in U.S. Treasury debt, that's only 18 percent of the $13.9 trillion treasury market. Foreign investors own nearly $6 trillion in treasuries, or 43 percent of the market. But this could soon change.
Last summer we wrote about how $13 trillion of worldwide debt had negative yields.
But over the last few months — according to Bloomberg — as inflation expectations in Europe and Asia have grown, more than $3 trillion of that negative-yielding debt has turned positive. This could be the start of a large wave of plummeting bond prices (as bond yields go up, bond prices go down) as the central banks of Europe and Japan continue to move away from their experiments with negative-interest-rate policies.
This could have huge consequences for the U.S. bond market, as foreigners who have poured vast amounts of money into higher-yielding U.S. treasuries turn to more viable fixed-income products at home.
In summary, the two most important buyers of treasury debt over the past several years (the Fed and foreign buyers) could be stepping away at the very same time. The impact on interest rates and the bond markets could be far greater than most imagine.
If President Donald Trump's stimulus agenda is successful, short-term rates may pick up a little but likely will be suppressed to fund the inevitable deficits. But while short-term rates may only go up a little, long-term rates could go meaningfully higher as events from above unfold.
If the Trump stimulus agenda fails, the economy slows or tips toward recession and then corporate defaults begin to rise. This would be painful for bond investors whose tiny yields provide little protection against the risks of not getting paid back.
So where should investors turn?
We believe long-duration bonds are clearly fraught with risk. The broader stock market also seems fully valued. Blindly throwing money at either asset class seems silly. Instead, we believe investors must continue to hunt in the few patches of value that still exist, while holding a buffer of cash to go shopping with when the eventual fears return.
Jonathon Fite is a managing partner of KMF Investments, a Texas-based hedge fund. Jonathon is a lecturer with the College of Business at the University of North Texas. This column is provided for general interest only and should not be construed as a solicitation or as personal investment advice. Comments may be sent to email@KMFInvestments.com.