Inside This Issue

September 2011
Volume 29, Number 9

Whither Bond Yields?

By Glenn Ezard

Bond yields are disappearing. At approximately 2%, the yield on the 10-Year U.S. Treasury note is at the lowest level on record since an accord between the Federal Reserve Bank and the U.S. Treasury removed the cap on government bond interest rates in 1951.1 Moreover, the yield on most high-quality bonds is now below the current rate of inflation. Negative real interest rates (the yield on bonds, net of inflation) means the interest income is not sufficient to offset the erosion of purchasing power from inflation. It is tantamount to sacrificing a portion of principal at redemption in return for safety.2 Investors need to consider the portfolio implications, given the Federal Reserve monetary policy, which includes an intent to maintain short-term rates near zero until the middle of 2013.3 This article addresses ways to measure the potential for loss in a fixed-income portfolio as well as potential portfolio adjustments.

Outlook for Bond Returns
The above graph charts the beginning yield and 10-year forward return for the Barclays Aggregate Bond Index, a widely followed benchmark for core fixed-income investments (highly liquid diversified investment-grade bonds). It includes government bonds, corporate bonds, and structured fixed-income securities such as mortgage-backed securities. For most portfolios, core fixed-income investments constitute the stable income-producing asset class. As the graph shows, the 10-year forward return is closely aligned with the beginning yield, with a correlation of 0.89.4 Therefore, the current 2.3% yield of the Barclays Aggregate Bond Index is also a good estimate for the expected 10-year return on a core fixed-income portfolio. Intuitively, this makes sense, as yield is generally the majority of return for a bond.

Interest-Rate Risk or Credit Risk
There are two primary ways to add yield in a fixed-income portfolio: take on higher credit risk, or take on higher interest-rate risk. Bonds with higher credit risk have a higher chance of loss through default, or failure to repay the debt. At the extreme end of the credit spectrum, a bond with a speculative credit rating has a higher risk of default than does a U.S. Treasury bond, and therefore pays a materially higher yield to the investor.

Interest-rate risk on a bond is referred to as duration. Duration measures the percentage change in price for a change of 1 percentage-point (100 basis points) in interest rates. Table 1 shows an example of how the total investment return for a bond that matches the Barclays Aggregate Bond Index (which currently yields 2.3%, as noted above) and has a duration of approximately five years would change if the yield changes. If the index yield rises by 1 percentage point, to 3.3%, price would need to adjust down by 5%. Note that in this instance, the price decline would exceed the annual income yield, resulting in a total return loss of approximately 2.7%. An adjustment of yield up to 4.3% - near the average for the 10 years that ended June 2011 - would represent a loss of approximately 7.7%. For context, the Barclays Aggregate Bond Index has not suffered a loss of that magnitude since the first quarter of 1980, when the Federal Reserve was fighting rampant inflation.

Table 2 displays the tradeoff between safety of principal and yield among fixed-income segments. For example, high-credit quality U.S. Treasury notes with an average maturity of two years offer a very low yield of 0.2%. Extending out to a maturity beyond 20 years offers additional yield of 3.2%, but it also compounds the potential for loss when interest rates rise. Accepting a higher risk of default is another way to gain yield. U.S. corporate high-yield bonds - which have the greatest risk of default - have interest rate risk comparable to the higher credit quality Aggregate Bond Index, but offer an 8.7% annual yield. Note that most bond yields do not keep pace with the recent rate of inflation.

Implications for Investors The Federal Reserve's recent statement indicates a monetary policy of low interest rates for at least another two years, undercutting the outlook for bond investors. With diminished return expectations for high-quality bonds, investors will look elsewhere to improve investment performance expectations. Options include the following:

1. High-yield bonds. Adding this investment can provide a boost to a portfolio's overall cash yield. However, the higher credit risk derived from lower quality bonds introduces equity-like risk into the bond segment of a portfolio.
2. Private-market debt. These bonds are less liquid than publicly traded debt. Moreover, they are generally unrated and of a lower credit quality. However, yields are significantly higher than publicly traded bonds with comparable maturity.
3. Higher dividend stocks. These strategies are another way to address the shortfall in cash flow. However, they are often concentrated in slower growth industries and companies that will also have lower prospects for capital appreciation.
4. Real estate and infrastructure equity investments. These investments can also provide stable cash flows, along with a volatility that is generally less than that of listed stocks, but typically more than bonds. Most choices will entail assuming a higher level of portfolio risk, and there are few options for replacing the steady cash flow of bonds. Moreover, private-market vehicles such as private debt are less liquid than high-quality publicly traded debt. A review of spending needs, such as a liquidity stress test of the portfolio, might be useful for investors requiring ready access to a significant percentage of assets.

1. For a discussion of historical interest rates, see the "alphaville" section of the Financial Times website (http://ftalphaville.ft.com/blog/2011/08/18/657036/treasuries-lehman-fied/) and the following report from the Federal Reserve Bank of Richmond: http://www.richmondfed.org/publications/research/special_reports/treasury_fed_accord/background/.
2. For more information on negative real interest rates, see the text box, "Negative Real Interest Rates: Shifting Debt Burden from Borrower to Lender," on page 3 of Segal Advisors' July 2011 Segal Advisory: http://www.segaladvisors.com/publications/july11segaladvisory.pdf.
3. This was announced in the August 9, 2011, statement of the Federal Reserve's Federal Open Market Committee: http://www.federalreserve.gov/newsevents/press/monetary/20110809a.htm.
4. That is a high correlation; a correlation of 1.0 between two numbers means that they move in perfect tandem.

Return to article

Glenn Ezard is a Senior Consultant in Segal Advisors' Los Angeles office. He can be reached at gezard@segaladvisors.com. This article is reprinted by permission of Segal Advisors, Inc., the SEC-registered investment consulting affiliate of The Segal Company. © 2011. All rights reserved.

Banking: Pay Attention to Avoid Paying Fees

By Linda T. Patterson

Getting the most from your banking relationship requires paying attention to costs throughout the contract period, not just during the RFP process. Banking costs are high, but managing those expenditures does not mean simply cutting services. In fact, if you monitor and use banking services judiciously, cuts might not even be necessary.

An Initial Internal Review
Before undertaking any bank proposal or bid process, you'll need to conduct a realistic review of your own operations. The organization's bank account analysis will show you what services are being used. Don't assume that you know - odds are you don't. Check the analysis and talk to your staff. If you do not receive an analysis from the bank, you will have to gather the information internally.

As a general rule, manual functions are expensive. In fact, many banks specifically price services in a way that prods clients into using more automated services and service delivery. For example, most banks provide statements and notifications online for a minimal service fee, or for free. But if you choose to get a paper copy instead, it usually costs more. Check your account analysis for key words such as "fax," "call," "notification," or "paper" and try to eliminate the service. Also review the way your organization handles coins and currency, since you incur internal handling costs, too. Consider a new option like smart safes, which immediately credits deposits, allowing you to save on armored car pickups.

Another cost saving measure is to stop services temporarily when they are not effective or needed. As an example, in our current low-interest rate environment, sweeps to money funds are earning little, if anything,, so consider temporarily eliminating them. And when volumes fall in an account, full reconciliation may not make as much sense as partial reconciliation. You can also eliminate services that once made sense but are no longer necessary. For example, controlled disbursement is often effectively replaced by sweeps (when interest rates are higher) and a little internal planning.

Another cost saving measure is to stop services temporarily when they are not effective or needed. As an example, in our current low-interest rate environment, sweeps to money funds are earning little, if anything,, so consider temporarily eliminating them. And when volumes fall in an account, full reconciliation may not make as much sense as partial reconciliation. You can also eliminate services that once made sense but are no longer necessary. For example, controlled disbursement is often effectively replaced by sweeps (when interest rates are higher) and a little internal planning.

Competitive Bids
To assure competitive rates, you'll need a competitive procurement process. Even if your organization is not required to periodically issue a competitive RFP, doing so allows you to discover new services, assure the best fees, and receive upgraded technology. A standard bank contract should not extend beyond five years, and to keep the bank on its toes, it's a good idea to structure it as three years with a possible two-year extension.

During a competitive RFP process, all fees need to be determined and agreed to before the contract is signed. Hidden or less obvious fees should be ferreted out and understood. The proposal should include all the fees that will be charged for providing each service - maintenance costs, transmission costs, and detail costs.

There's even a price for that coveted FDIC insurance - an average of 13 basis points at major interstate banks. This cost has to be considered if you are using non-interest bearing accounts for FDIC insurance coverage only (not as for a target balance) because you're paying the bank to hold your money.

Another hidden cost is collateral. Collateral pledged to a public entity basically costs 10-12 basis points. Low interest rates currently make sweeps unrealistic, but when rates rise, a sweep to a money market fund takes funds out of the bank and reduces the collateral cost, saving you money. Reducing your balances in the bank and using that money for other investment options can also net higher earnings. If your money is earning 1% in the bank, but you're paying 10 basis points in collateral costs, you're getting a net 0.9% return. Instead, you might want to consider other investments at 1% (with cost of transaction) as a better investment.

Learn to ask for all the costs involved in providing a banking service. Some banks bundle services such as positive pay and online reporting or imaging, but some cost out every step in the process. Ask for all the details and fees, especially if you're coming from a bundled environment. For example, imaging might be one net cost of $25 a month at one bank, but another bank will charge one fee for capturing the image, one for retaining the image, and one when you retrieve the image. Apply those detail volumes and the true cost will be evident. Another example is clearing checks. A fee of 5 cents per check might look higher than another bank's fee of 4 cents, but only if the second bank does not charge another 2 cents to encode the check. Be sure to build in your volume estimates to accurately project your costs. High-volume activities such as ACH should be tested at current and future volumes to test the impact at various banks.

The bank should let you choose to pay for services on either a fee basis or a compensating balance basis. You should generally use a compensating balance (paying for services by leaving money in the bank) to pay for bank fees when the federal funds rate drops to less than 3% - that's where the earnings credit rate (ECR) at which you earn interest to pay the bank fees becomes greater than outside rates of investment. For example, with money fund and pool rates currently hovering at 0.05% to 0.1%, the ECR at your bank is probably closer to 0.3%, and as high as 1%. Leave the funds in a compensating (target) balance and earn the higher rate now. When Fed funds increase to more than 3%, the ECR tends to be half of the interest rate available from outside investment alternatives, so then the funds should be maintained or invested elsewhere. The ECR is a rate you should monitor at least quarterly to determine how you pay for banking services. When rates are better outside the bank, take the funds out and pay fees.

Look to New Services
New services are often more highly automated and less expensive than existing services, so ask your banker to bring new services for review. Remote deposit brings the teller operation into your organization but cuts float, courier costs, and courier liability. Stored value cards dramatically cut payroll issuance costs and can add flexibility to other uses, such as expense reimbursement. Image lockbox can replace heavily staff-intensive receivables work.

As banks move further toward being service providers and offer more e-payable and e-receivable services, they will provide many options for streamlining your own operations and while using the banks' computing capacity. For example, some banks charge a minimal fee for scanning and archiving of all historical types of documents. Some banks even use ECR credits for supplemental services such as printing.

Monthly Monitoring
Finally, monitor costs monthly. When banks reload programs, standard pricing can slip back into your account analysis. Use the analysis to verify that contracted prices are still being applied. Simply create a spreadsheet for monthly volume input against the contracted price (see right). If your total charges do not agree with those on the analysis, contact the bank immediately to have the correct contracted fees applied.

Conclusions
Banking is expensive, but if you pay attention during the RFP process to your own operations and the way you use services, and monitor costs throughout the contract period, you can probably pay less.

Linda T. Patterson is President of Patterson & Associates. She can be reached at linda@patterson.net.

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Interest Rate Outlook

Panel of Economists

Given the Congressional wrangling over the nation's debt limit, the sovereign debt situation in Europe, and the less-than-ideal economic data in the United States, what do you expect from the economy through year's end?

James Glassman, managing director and senior economist at J.P. Morgan Chase and Co., said: "The political turmoil is unlikely to have a visible impact on the economy. I continue to anticipate that the U.S. economy will speed up gradually over the second half of the year, as the disruptions to the global motor vehicle industry stemming from Japan's tsunami pass and as the reversal of earlier oil price increases, which might have slowed the U.S. economy's momentum by several percentage points, show up at the pump."

Lacy H. Hunt, executive vice president of Hoisington Investment Management, said: "A meaningful risk exists that the economy could turn down prior to the general election in 2012, even though this would be highly unusual for presidential election years. The econometric studies that indicate the government expenditure multiplier is zero are evidenced by the prevailing, dismal business conditions. In essence, the massive federal budget deficits have not produced economic gain, but have left the country with a massively inflated level of debt and the prospect of higher interest expense for decades to come. This will be the case even if interest rates remain extremely low for the foreseeable future. Unemployment will remain unacceptably high and further increases should not be ruled out. The weak labor markets could in turn force home prices lower, another problematic development in current circumstances. Inflationary forces should turn tranquil, thereby contributing to an elongated period of low bond yields. The Fed may resort to another round of quantitative easing, or some other untested gimmick with a new name. Such undertakings will be no more successful than previous efforts that increased over-indebtedness or raised transitory inflation, which in turn weakened the economy by directly, or indirectly, intensifying financial pressures on households of modest and moderate means.

"While the massive budget deficits and the buildup of federal debt, if not addressed, may someday result in a substantial increase in interest rates, that day is not at hand. The U.S. economy is too fragile to sustain higher interest rates except for interim, transitory periods that have been recurring in recent years. As it stands, deflation is our largest concern, long term."

"Treasury bond yields should continue to move irregularly lower."

John Lonski, chief economist, Moody's Investor's Service, and Ben Garber, an economist at Moody's, said: "Recent data on retail sales and industrial production still reflect an intact recovery, though financial market volatility threatens the outlook. Provided smoother functioning markets than the past couple weeks, the U.S. economy can still expand in excess of 2% in the second half of this year."

Snapshot of Economy and Interest Rates

Economic Summary

Moving Averages

6-Month Treasury Bill

2-Year Treasury Note

10-Year Treasury Note

Investment Performance Benchmarks

The money market fund index

S&P Rated LGIP Index

Key Rates: Cash Markets