Horizon Kinetics: Bond Investors Don’t Consider Low Coupons Staying Low

Another way to understand the financial crisis of 2012 is to look at the basic characteristics of the iShares Barclays Aggregate Bond Fund (NYSEARCA:AGG). The reason the AGG metrics are very useful is that this index purports to represent the entire investment grade U.S. bond market. Even though individual bond investors might have characteristics very different from AGG, collectively, all the bond investors in the country look essentially like this index.

Imagine if one deposited $10,000 in a bank account and left it there for six years, receiving an annual rate of return of 1.41%. That would be equivalent to the stated yield to maturity for the iShares Barclays Aggregate Bond Fund (NYSEARCA:AGG), which is the best estimate of its future rate of return. However, the Form 1099 received for an investment in AGG would state that the fund paid 2.44% annual interest and one would be taxed on that amount.

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From the point of view of the depositor, the concern is the after-tax rate of return. Assuming New York City tax rates, that after-tax rate of return would be around 19 basis points per year. That is the dilemma of the bond investor. An investor in this index is taxed on a distribution yield of 2.44%, so what’s essentially happening is that one is converting principal into taxable income. If the bonds trade above par, ultimately they will gravitate to par, because they will mature, be called, or be tendered.

It’s a little bit worse than earning 19 basis points a year, because it’s not really a bank account. iShares Barclays Aggregate Bond Fund (NYSEARCA:AGG) is a bond fund and, because the bonds gradually but inexorably gravitate towards par, the end value will certainly fall. Let’s imagine that the current premium to par 6 years hence were to erode merely to par; a $10,000 investment would have a principal value of $8,500. That’s the dilemma of the bond investor and that’s really the best measure of the financial crisis of 2012.

Another problem is that as the higher coupon bonds either mature or are called, the coupons inexorably gravitate lower, and the convexity increases. Convexity, the inherent risk of this portfolio, is inversely proportionate to the coupon: the lower the coupon, the higher the convexity. Therefore, the risk of this fund is increasing.

A given individual investor might be sufficiently sensible to avoid this fate but, as a whole, what will happen to the nearly $37 trillion of bond capital that exists in this country? The situation that was just described regarding iShares Barclays Aggregate Bond Fund (NYSEARCA:AGG) is ultimately going to happen to that $37 trillion.

As unpleasant as that trend might be, one might think a greater danger would result if rates increase. It’s only a different danger. Even though the market value of those bonds would decline if rates increase, at least the coupons would be higher and there would be some compensation. At the end of the day, there are actions one can take in such a circumstance if one is sufficiently prescient to anticipate the problem.

Some examples of actions one could take include shortening the average maturity, selling short zero coupon bonds, buying options, or one buying interest rate swaps. There are ways of hedging oneself against that circumstance, were it to occur, but there’s nothing to be done if the coupons keep gravitating lower, because the opportunity set is based on what exists. One can’t create higher coupons from an opportunity set of low coupons. That is the issue of reinvestment rate risk.

Almost all of the academic literature on bonds deals with the question of how to control the volatility of the bond portfolio in the event that interest rates rise. There’s really nothing to speak of that deals with the issue of reinvestment rate risk. The world of bond investors and the academic world are completely unprepared for the circumstance in which the low coupons remain low for a very long period of time.

Via Horizon Kinetics