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Friday, May 11th, 2012
a bad bet

This is the first posting in a series inspired by the CFA Institute’s annual conference.  Unlike other series I have done, this one will jump back and forth between this site and essays about the research puzzle.  (A PDF index of the postings will be updated as each is published.)

As is always the case, a good conference overwhelms you with ideas, and this one surely did.  So let’s start simply, by focusing on what is likely the most important investment issue extant:  low interest rates.  At a preliminary “research for the practitioner” seminar, Gary Brinson commented on the “financial repression” of negative real interest rates in our economy — a phrase that was used in various contexts thereafter by others.  He said that “we will pay for it.”

Many speakers alluded to the bad bet that bonds seem to be at this point in time.  A contrarian might hear that and think that there’s more room to go — and investors need to consider all scenarios.  But professionals are clearly worried about fixed income investments.

Retail investors have piled in, most unaware of the bond math that makes their expectations hard to realize.  Bond managers are caught between the risk in the market and career risk (not unlike that for stock managers trying to deal with Apple).  And many institutional investors have huge holdings in bonds and limited flexibility in minimizing the risk.

The chart above, using the Barclays Aggregate (the ETF for which is AGG) , summarizes the situation.  Returns have been great on bonds for a long time, resulting in emotional comfort and solid looking-backward results, the one-two punch for many investment decisions.  Christopher Ailman, the chief investment officer of CalSTRS, reminded the audience that the decline in yields that led to those results (and which had actually started eight years prior to the period shown) had another effect, for some first learned when they studied for the CFA Level I exam.

All else being equal, the duration of bonds increases as rates go down.  All else isn’t equal, of course, and the series above includes changes in sector composition, movements across time, and even methodology adjustments.  Lengthy handbooks are written about such things.  Here’s the executive summary:  If interest rates rise, it won’t be good.  (Chart:  Bloomberg terminal.)

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