Tuesday 11 April 2017 by Mark Bayley Trade opportunities

Warning – Yield curve steepening ahead

What happens in the US market influences markets here in Australia. So, while a steepening of the US treasury yield curve may seem irrelevant, it could impact the prices of bonds in your portfolio

steep climb

Last week, the US Federal Open Markets Committee (FOMC) released the minutes of their most recent meeting. These minutes highlighted that a majority of members would like to see a reduction in the quantity of bonds and mortgage backed securities held on the Federal Reserve’s balance sheet, which currently stands at USD4.5 trillion. An unwind of this massive pool of assets, even if well signalled, should result in a steepening of the yield curve. If this is the case, we expect long duration bonds to sell off.

One key section of the FOMC’s Minutes of the Meeting that investors should focus on was (emphasis our own):

“Provided that the economy continued to perform about as expected, most participants anticipated that gradual increases in the federal funds rate would continue and judged that a change to the Committee’s reinvestment policy would likely be appropriate later this year. Many participants emphasized that reducing the size of the balance sheet should be conducted in a passive and predictable manner.”

The Fed’s asset maturity profile is shown in Figure 1.

Maturity schedule of assets held by the Federal Reserve


Figure 1
Source: Bloomberg, US Federal Reserve

The Fed is a significant investor in US Treasury markets and if they do start to reduce holdings – most likely through non re-investment of coupon and principal redemptions – it is likely to lead to a steeper yield curve as demand for US Treasury bonds will necessarily fall. This is a de facto tightening of monetary policy and, in 2018 alone, would amount to an extra USD425bn.

A likely secondary impact of this tightening policy is that the FOMC will not have to hike its cash rate as quickly as the market currently expects. This adds to the steepening bias and reinforces our preference for shorter dated securities.

If the US Treasury yield curve does start to move higher, secondary market long dated bonds are likely to sell off. Some clients will recall the Taper Tantrum of 2013 when Chairman Bernanke signalled the end to Quantitative Easing. This resulted in a dramatic surge in Treasury yields – a selloff in prices – that carried through to AUD denominated assets, including bonds. Indeed, over the last month the AUD yield curve has rallied strongly (yields lower, prices higher) which could exacerbate the problem. This is shown in the darker blue yield curve line below.The bar chart underneath shows the resultant change in basis points.


Source: Bloomberg

 ‘Modified duration’ can give investors an idea of the price sensitivity of a bond to a change in interest rates. The greater the duration, the greater the sensitivity and may help identify which positions to reduce.

If you agree with this analysis and would like to position for further curve steepening, these are the trades we recommend.

Security Modified duration Coupon type Structure Sector Capital price Yield to call/ maturity Credit margin Currency
Sell
TRANSALTA-6.50%-15Mar40-USD 
11.29 Fixed Senior debt Energy 92.750 7.15% +4.56% USD
QTC-6.5%-14Mar33
10.84 Fixed Senior debt
Semi Government 137.713 3.41% +0.27%
AUD
BHP BILLITON-6.75%-19Oct25c-USD
6.40 Fixed Sub debt Resources 112.850 4.89% +2.61% USD
WBC-4.80%-14Jun23c
5.08 Fixed
Tier 2 Major bank 103.068 4.22% +1.66% AUD
Buy
TRANSALTA-4.50%-15Nov22-USD
4.81 Fixed
Senior debt
Energy 100.375 4.42% +2.35% USD
NRW-7.50%-19Dec20
3.20 Fixed Senior debt
Other corporate 100.900 7.01% +4.83% AUD
GENW-BBSW+3.50%-03Jul20c
0.36 Floating rate note Tier 2 Property 103.310 4.43% +2.39% AUD
Source: FIIG Securities
Indicative mid mark pricing only, accurate as of 11 April 2017 but subject to change

Not all high duration bonds are likely to suffer, however. Long dated bonds with high credit margins have historically performed better in an environment where benchmark yields rise, due to those margins contracting. Holders of some longer dated bonds including CenturyLink and NCIG can take some comfort from this, but should nevertheless consider their interest rate exposure. Those bonds we have identified to sell trade at a relatively low credit margin and historically have moved in line with broader market prices.

Investors who would like to review their portfolios should contact their dealer.


Glossary

Modified duration

Modified duration is a measure of a portfolio’s sensitivity to movements in interest rates, and the percentage change in a bond's price for a 1.00 percent change in the whole yield curve. For example, a portfolio with a three year duration would lose 3% if that interest rate curve moved up by 1% across the whole curve. Conversely, a 1% downward move across the curve would result in a 3% gain. In reality, the curve rarely moves in parallel and it will typically move by different amounts for different tenors.

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