Yield curves and recessions

If the U.S. goes back into recession in 2013, stock markets will suffer. So getting a bond strategy right will be very important.

In my previous two columns, we discussed how low interest rates have made bonds super-sensitive to rate changes. We discussed how laddering strategies using ETFs are a conservative all-purpose approach in most circumstances (see Bearing up with bonds) and how experienced advisors may use barbell strategies to optimize their views about yield curve steepening or flattening (see “Henderson has scored for Canada!”).

ETFs make implementing fixed-income strategies easy; but which strategy should you use now?

A last-minute congressional deal that pushes the fiscal cliff back a year or more is the most likely development. This may mean fiscal economic drag of 1.5% to 2%.

In Canada, the risk of recession may be reduced, so the slope of the yield curve should not change much (see “Canadian yield curves”). A laddered strategy or a barbell should be fine in this circumstance. However, there is a wide range of possibilities between the worst and best cases and even the likely instance is far from a certainty. The conditions are unprecedented.

Worst case: Falling off the cliff

The worst case is gridlock; no extensions, and the economy tanks. Buying government bonds has always been the correct strategy in these situations of maximum uncertainty (see “Worst-case portfolio,” below).

Worst-case portfolio

Best case: Congressional harmony

The economy’s best hope is for a deal that restores consumer and business confidence in the future. Congress can’t do it alone, so this may be the long shot. Improving economic conditions may lead initially to a steeper yield curve.

However, the Bank of Canada has already threatened higher interest rates. So our policies may lean against those of the U.S. at our peril. A steepening trade, or a longterm ladder, may be the best way to position for this initially. A flattening trade or floating-rate ETFs are good defensive approaches if prosperity breaks out and the economy overheats later.Consider liquidity, particularly on short sale trades.

Best-case portfolio

Canadian yield curves

Source: PUR Investing

Likely case: Same old, same old

A flattening yield curve, and often an inversion (short rates exceed long rates), are precursors to economic slowdown. Not only does the demand for short-term inventory financing drive up short rates at the end of a business cycle, central banks usually raise rates to lean against inflationary pressures. Ultimately, inventory liquidation triggers the recession that follows. The slope of the current yield curve (see “Canadian yield curves,” right) looks more like the one in 2003 that preceded slowing quarters in 2003-2004—when we had no recession—than the flat one at the end of 2007. Of course, the 2008 crash followed.

If congressional negotiations are slower than expected (and they likely will be), the economy may sputter, but the yield curve should flatten to signal this. But since central banks have maintained an artificial credit environment, the old rules may not apply. Otherwise the curve should stay as steep as it is currently. In this environment, ladders are again a good strategy because they benefit from yield-curve roll down.

Over time, assuming stable rates, as a bond with a 7-year maturity rolls down to become a 6-year maturity, the coupon remains fixed but yield falls, meaning that the bond’s price rises. This cushion provides some protection against rate volatility, something that should be in abundant supply.

ETF users should note that fixed-maturity ETFs are great for this situation, but fixed-term barbells from First Asset (GXF, AXF, KXF) only benefit from this yield-curve roll-down advantage inside the ranges of each barbell: one year-to-two years at the short end, and 10 years-to-20 years at the long end. They sell the 10-year bonds when they fall under the long-end range.

There is much to consider with bond tactics through year-end and into 2013. While ETFs make implementation easier, picking the right approach isn’t simple. A view, good timing and a sense for how rates have moved in the past are requisites to making the right decision.

Special thanks to Edward Orfao, CA, CFA for his bond expertise.

Mark Yamada

Investments

Mark Yamada is president of PÜR Investing Inc., a software development firm specializing in risk management and defined contribution pension strategies.