SVB and Individual Investors Shared a Common Problem: Falling for the Illusion of Safety from Fixed-Rate Debt
Treasury bonds seem like a safe asset. You invest in them, and many years later the US Treasury, one of the most trusted institutions in finance, pledges to pay you back. Along the way, you get some interest income.
But Treasury bonds aren't necessarily safe if interest rates go up and you need the money in the meantime.
That can be demonstrated by the real-life example and illustrative example below.
Real-Life Example: SVB, a very successful bank serving the tech ecosystem, had been flooded in recent years by a huge increase of deposits due to the massive growth of capital being invested in the technology sector. Unlike most commercial banks, SVB didn't do a whole lot of lending itself, because startups don't generally need loans. So SVB had to invest that money somewhere, and that money went into Treasury notes and bonds.
But because interest rates had gone up so fast in the last twelve months, the market value of SVB's bonds went down from a market value standpoint, and that created paper losses for the bank. In fact, the market value of the bank went down so much that SVB had blown through a significant amount, if not all, of its Tier 1 Capital. That led to a classic bank run, and within 48 hours of announcing that it was trying to raise capital, SVB was shut down.
Illustrative Example: Joe and Betty Cautious (fictitious name) retired at the end of 2021 at the age 67. They figured that they were in pretty good shape - between social security and a 5% withdrawal rate, they could have a comfortable retirement with a little bit of emergency savings built in. Joe and Betty had relatively low risk tolerance, so they invested in a portfolio consisting of 40% stocks / 60% bonds.
Fast forward 12 months: Joe an Betty look at their investment statements, and they see that between their 5% withdrawal and a -15% market return, their retirement portfolio is down 20% in one year. They wonder if they still have enough money to make it through retirement, and they're definitely concerned about the possibility of being down another 15-20% in 2023.
What's the commonality between SVB and the Cautious family? Both got whacked by the illusion of high-quality, long duration bonds being "safe." To be clear, most investment-grade bonds (especially Treasury bonds) are safe over the long term. But long-maturity bonds are definitely not safe in the short term.
It's not totally surprising that both amateur and professional investors have forgotten that bond market value can decline.
Bond investors have been essentially been spoiled over the most of the last 40 years. It may be hard to believe, but yields on 10-year Treasurys peaked at 15.84% in September 1981. From 1981 to 2020, it was nothing but a bull market for bond investors, with 10-year Treasury yields eventually bottoming out at 0.54% on March 9, 2020.
A 40-year bull market naturally creates an atmosphere of complacency. Think about it: today's generation of bankers and financiers has seen zero downside in investing in long-term fixed-rate debt. And even when corporate bonds wobbled, it always seemed that in a crisis there would be a flight to safety in Treasurys.
But as every finance professional knows, when interest rates go up, the price of existing bonds goes down. And the longer the maturity, the more that the price of bonds go down. When inflation started rising in 2022 and the Federal Reserve started raising rates, it was almost inevitable that investors would learn that, yes inflation is bad for bad bond returns.
Individual investors and financial advisors re-learned this lesson the hard way in 2022. According to Aswath Damodaran's investment returns dataset, Treasury bonds and corporate bonds in 2022 had THE WORST calendar year returns in the dataset, which goes back to 1928.
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I have always had some misgivings about the high proportion of fixed-rate debt in investment portfolios.
But I had especially large misgivings about the concentrations of fixed-rate debt holdings coming into 2022, especially after the outbreak of the war in Ukraine.
This is why I advised many of my clients at the beginning of 2022 to go overweight on short-term bonds and corporate bonds. I also advised some clients to buy floating-rate debt. I-Bonds of course were a good choice, even though there was an annual $10,000 limit and a high cost of hassle in dealing with TreasuryDirect.
But now I'm starting to think this advice was not just a correct tactic for 2022. I think this advice might be correct as a long-term strategy.
Some of the things I'm thinking about are the following:
Is the additional volatility from longer-term maturities worth bearing to get additional return, especially when the client is an individual investor?
Should we be diversifying clients' fixed-income portfolios into more variable-rate or floating-rate debt?
Let's talk about each of these points individually…
Move to Short-Term Bonds?
First, let's compare some statistics for two well-known bond funds. The Vanguard Total Bond Admiral Shares (VBTLX) and the Vanguard Short-Term Bond Admiral Shares (VBIRX):
Effective Average Maturity
Total Bond: 8.9 years
Short-Term Bond: 2.8 years
Effective Duration (note: if you aren't absolutely sure what "duration" means, here's the definition.)
Total Bond: 6.57 years
Short-Term Bond: 2.6 years
Monthly Volatility - Last Three Years
Total Bond: 6.11%
Short-Term Bond: 2.62%
Let's ignore the current inverted yield curve and instead assume that on average you get somewhere around 50-75bps of additional yield on maturity spread between a short-term fund and a total bond fund. Is it worth it? Maybe technically, it is worth it. But for retail clients, I'm not sure that the fixed-income portfolio is where they should be taking risk to eke out additional returns.
And that's especially true right now. Sure, medium term bonds could rally meaningfully if inflation and interest rates come down….but is it worth the risk? I'm dubious. And a broader question, why have we been making a portfolio allocations that provide concentrated exposure to interest rate risk?
I have more work to do on this point, but my theory is that fixed-rate bonds with maturities greater than 5 years may not be a good holding for retail clients, especially from a client management standpoint, and that our risk allocation may be better placed in other asset classes.
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Floating-Rate Debt: Good In Theory, Challenging in Practice
In theory, moving a portion of clients' portfolios into more floating-rate / variable-rate debt would be great. That would allow us to significantly reduce interest rate risk. In practice, there are a few problems:
Problem #1: Investment grade floating-rate debt generally has lower yields than fixed-rate. Investment rule of thumb: less volatile assets are likely to generate lower returns, and that is definitely true for floating-rate debt relative to fixed-rate debt. In this research note from Schwab, floating rate notes generally yield 25-100bps less than their fixed-rate short-term counterparts.
Problem #2: The size of the floating-rate market isn't currently large enough to support a large-scale shift of investment holdings to floating-rate debt. A big reason for this is that most borrowers (with except of publicly-traded lenders) generally hate issuing floating-rate debt. It's just like when you're getting a mortgage to buy a house: would you rather have a fixed 4% fixed-rate 30-year mortgage, or would you rather have a 3.5% mortgage for the first 5 years, after which the interest rate could go up to as high as 8%. Most mortgage borrowers would prefer to have the fixed-rate mortgage and not have to stress about changes in the interest rate in the future. The same is true of all institutional borrowers as well (even the U.S. government hates floating rate notes, and the US Treasury only issues floaters with two-year maturities).
The use of interest-rate swaps could potentially solve this supply problem. But retail investors have little access to swaps, except through a few funds (as noted below). And those funds have their own risk, especially the introduction of counterparty risk in conjunction with the swap contracts.
Problem #3: Most of the floating-rate / variable-rate investment options have material downsides. Let's review some of the options for investing in floating-rate or variable-rate debt:
Treasury Inflation-Protected Securities ("TIPS") are advertised to provide protection against inflation, but in practice, they are very complicated securities whose protection is quite difficult to analyze. For instance, Vanguard's Inflation Protected Securities Fund Admiral Shares was down 11.85% in 2022. The reason behind TIPS underperformance was very well explained in this research note from Charles Schwab about TIPS' disappointing 2022 performance. But despite this good explanation, "normal people" don't understand how this can happen. Normal people would say, "Hey, there was inflation, I owned TIPS, and my bonds went down a lot." And they're right.
I-Bonds are bonds issued by the US Treasury exclusively through TreasuryDirect. There are two downsides: (1) an individual can only buy $10,000 of I-Bonds per year (although there are some cumbersome ways to potentially put in more each year); and (2) TreasuryDirect is a pain to deal with. I think I-Bonds are a great thing to buy for all investors, but building a meaningfully sized portfolio takes consistent effort over many years and adds complexity to overall portfolio management. In addition, I-Bonds can't be held in an IRA, which is a bummer, although you can elect to defer the gain until the bonds are redeemed. You also lose three months of interest if you redeem I-Bonds within five years of purchase. There is a large cost of hassle involved in building a meaningful I-Bonds portfolio, but for longer-term investors willing to put in the work, it's probably worth the hassle to put in place an effective hedge, even after inflation recedes.
Treasury Floating-Rate Notes. Little-known among financial advisors, Treasury Floating-Rate Notes are not bad as a short-term instrument. The problem that I have with them is that Treasury has only issued notes with 2-year maturities, so yields tend to be very low. It's not clear to me whether this is significantly better than just investing in an ultra-short fund or T-Bills.
Corporate Floating-Rate Notes are corporate bonds issued by investment-grade companies with floating rates that adjust as LIBOR SOFR moves up and down. The big problem with floating-rate notes is that issuance is dominated by the financial sector; about 50% of outstanding debt is issued by banks and other financial institutions. That level of industry concentration is concerning for anyone investing in a diversified floating-rate note fund. (Note to the asset management industry: I'd love to have a low-cost, index-driven FLN fund that excluded financials.)
Interest-Rate Hedged Bond ETFs use derivatives to essentially take out the interest rate risk of bonds. In theory, this approach makes sense, but in practice, it's tricky to implement an effective hedge. However, if executed well, such a fund can provide similar returns to floating rate notes, but with a more diversified portfolio. However, the interest rate swaps introduce counterparty risk as an additional risk factor (which again increases exposure to financial sector credit risk). To be completely transparent, I need to do more research on this product to see if it is a worthwhile addition to consider.
Leveraged Loans or "Institutional Bank Loans" are floating-rate loans to non-investment grade companies. A good portion of the debt in this market is related debt used to finance leveraged buyouts, but there is also meaningful exposure to the energy sector as well. Interest rates on leveraged loans are much higher than those on floating-rate notes, but because the credit worthiness of the borrowers is much worse, there is a much greater risk of default, especially if a recession hits. I personally like including leveraged loans as a small piece of portfolios for investors who have higher than average risk tolerance. However, one common complaint is that leverage loans have almost as much downside risk as equities, but much less upside. I don't completely agree with this point. My view is that from a risk-return-correlation standpoint alone, maybe leveraged loans don't add much value. But the fact that leveraged loans are also variable-rate is a bonus for inclusion in a portfolio. To demonstrate that point, while Treasury Bonds were down 15.9% in 2022 to Damodoran’s study linked above, the Credit Suisse Leveraged Loan Index was only down 1.9% in 2022.
Suffice to say, none of these options is ideal; moreover, most of these investments are somewhat complicated for regular investors to understand.
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2023 Is a Time to Reflect for Fixed-Income Asset Management
The point of this post was not to provide an answer on what an ideal fixed-income portfolio is going forward, but to shake the asset management industry and the portfolio analytics industry out of its fixed-rate and "total bond market" tunnel vision and really consider if how we construct portfolios today is serving clients well. If SVB was surprised by how fast bond markets can turn, how do you think retail investors feel?
And I think that should raise a few questions:
Is losing 15% in a year acceptable value-at-risk for a 40/60 portfolio?
Do portfolios have too much concentration of interest rate risk? Should we diversify into other types of risks within fixed income (especially increased credit risk)?
Or should we really view the fixed-income portfolio as the "rock" in portfolios, and make a clearer distinction that investment-grade fixed-income should be the "risk-off" in our portfolios and then use the remaining part of the portfolio to achieve optimized risk-adjusted returns?
Or is the perspective that we view 2022 as a 1 in a 100 year outcome that we shouldn't overreact to?
These are the types of questions that investment managers and asset managers should be asking during 2023. I hope this blog post kicks off a much needed dialogue. In the meantime, I'll be putting in some work to try to answer these questions for my clients, and in the coming months, I hope to provide some additional thoughts on this important issue for our industry.