Public Investor Interviews Portfolio Managers on 2005 Outlook
To gain insights on the 2005 investment outlook, in late January Public Investor (PI) conducted an “online interview” with portfolio managers from two investment firms representing state and local investors. The first firm was Chandler Asset Management, Inc., represented by Ned Connolly, CCM, and Ted Piorkowski, CFA. Connolly and Piorkowski both serve as vice presidents and portfolio managers with the firm. Susan F. Flischel, CFA, spoke on behalf of Seasongood Asset Management. Flischel is president of Seasongood, a registered investment advisor specializing in providing investment advisory services to public entities.
PI: The yield curve has flattened significantly in the past 12 months, with longer-term Treasuries essentially unchanged and shorter-term Treasuries higher. In your opinion, was this a historical anomaly or something that tends to happen in this stage of the economic cycle?
Chandler: Analyzing the relationship between two-year and 10-year Treasury Notes for the past 20 years, we observe that the average difference in yield between the two (the spread) was approximately 100 basis points. Typically, the spread widens, representing a steepening of the curve, prior to and in anticipation of the Federal Reserve tightening, or raising, the overnight bank lending rate. In contrast, when the Federal Reserve actually implements a tightening policy, the spread tends to narrow, representing a flattening of the curve. In the current cycle, the widest spread— i.e., steepest curve—of 274 basis points occurred in August 2003, 10 months before the Fed started tightening. The spread is currently 92 basis points, slightly under the average. The changes in the shape of the yield curve through the current cycle have been very typical.
Seasongood: The yield curve flattening in 2004 was in line with its historical behavior during a Fed tightening. The curve typically flattens when the Fed starts to raise the Fed Funds rate (or when the market believes the Fed is about to start). The short end of the yield curve is highly dependent on the level of the Fed Funds rate, so short-term Treasuries move in tandem with the [Fed] Funds rate.
The longer end of the yield curve is typically driven by other factors including inflation expectations. During 2004, the Fed was successful in taming inflation by raising short-term interest rates, so longer-term rates remained relatively flat.
PI: Were public-sector investors rewarded or punished for adoption of a defensive posture (i.e., shortening the duration of their portfolios) during 2004?
Chandler: A look at the annual total return for 2004 on market segments tells the tale. Observe the three-month T-Bill as a proxy for a short-term portfolio, compared to the Merrill Lynch 1-3 Year and 1-5 Year Government Indices—proxies for portfolios with longer durations, of approximately 1.6 and 2.3 respectively. The chart in Exhibit 1 compares 1) price return, which is the change in market value of the portfolio during the year, 2) income return, which is the income generated by each portfolio, and 3) total return, the sum of 1) and 2). 
Somewhat surprisingly, the best performing portfolio of the three was the longest—the 1-5 Year. Although the price return (market value) of this portfolio declined as interest rates rose, the return from coupon income was quite strong. Second best was the short-term T-Bill, which benefited from rolling promptly into higher yields as the Fed began aggressively raising rates in Q3 and Q4. The 1-3 Year suffered from a double whammy. Price return in that sector of the market was very severely impacted as short-term rates rose. Furthermore, income return was modest, since short-term rates were so very low at the beginning of the period.
Seasongood: In 2004, we felt it was a prudent decision for many public-sector investors to maintain a shorter duration or weighted average maturity. For the majority of public-sector investors who maintain a duration of less than two years, the shorter duration strategy proved wise.
Since the two-year Treasury started the year at a yield of 1.82 percent and rose 125 basis points to finish the year at a 3.07 percent, it would have been wiser to invest in something shorter term than the two-year Treasury. This would have allowed you to participate in the rising interest rate environment while experiencing significantly less market value erosion.
However, this defensive strategy would have been less attractive to those who were matching longer-term liabilities, such as in a debt-service or long-term reserve accounts. For the investor who typically invests in the 10-year sector, it would not have been advantageous to shorten at the beginning of 2004. The 10-year Treasury started the year with a yield of 4.25 percent and actually ended the year with the lower yield of 4.21 percent.
PI: Foreign demand appeared to contribute to a strengthening of prices of medium- and long-term Treasuries in 2004. Do you expect a repeat or reversal of that in 2005 (or beyond 2005)?
Chandler: Despite the weakness in the dollar and differences in politics, foreign investors still have an appetite for U.S. Treasuries. Even with the problems the government-sponsored enterprises such as FNMA experienced, foreign demand for U.S. assets remained strong throughout 2004 as it has in recent years. We expect foreign demand for medium- and long-term Treasuries to remain about the same in 2005 as the relatively high longer-term rates and the positive-sloped yield curve tend to drive the investment decisions of overseas investors. However, should inflation begin to trend up, economic growth become stronger, and/or the strength of the dollar change significantly, foreign interest in U.S. assets could be negatively impacted.
Seasongood: Foreign central banks have continuously been a significant player in the U.S. Treasury market. Over the past three years they have added nearly $500 billion of U.S. debt to their reserves. Currently foreign investors own nearly half of all outstanding treasury issues. If the dollar continues to weaken, we could face a period where foreign demand for treasuries could decline, causing even higher interest rates. Given the liquidity and safety of the U.S. Treasury market, we believe that any drop in demand would be moderate.
PI: Later in the year, say in six months, do you expect further flattening, a parallel shift upward, or essentially no change in the yield curve?
Chandler: We expect further curve flattening given the following conditions: 1) the economy experiences moderate growth of between 3 to 4 percent; 2) the Federal Reserve continues to tighten; and 3) inflation remains moderate. If economic growth were to fall below the 3 to 4 range, there may be less Fed tightening than currently anticipated and the curve may steepen as a result. The curve may also steepen if yields on longer-term securities rise in response to higher inflation.
Seasongood: The Fed is expected to continue raising rates at a measured pace keeping long-term inflationary pressures at bay, so we would anticipate that we would experience further flattening. However, if there were to be an unexpected rise in inflation, longer-term rates would most likely move higher, causing a steeper curve.
PI: Based on your yield curve expectations for 2005, what do you advise public-sector investors to do in terms of managing interest rate risk?
Chandler: We expect the yield curve to continue to flatten. We believe that public-sector clients are well served if they define and maintain a risk profile that matches their long-term objectives, and manage their portfolios accordingly. We do not recommend that public-sector investors base their strategies on timing interest rate changes. It is not that we think current interest rates are irrelevant. We manage interest rate risk through a highly disciplined approach of targeting the duration, the structure of the portfolio along the yield curve, and the asset allocation. Currently, our clients’ portfolios are structured to have durations that are approximately equal to their target durations, and in somewhat of a barbell structure because of the expectation for the yield curve to flatten.
Seasongood: Caution is in order for investing in a rising interest rate environment. Public funds officers need to be careful not to get caught up in buying the “big” coupon securities that are being offered. Many investors, after having experienced 1 percent interest rates, are now getting excited about seeing 3 percent and 4 percent coupons. Many of these investments have maturities that are longer than one year. With the Federal Reserve expected to continue raising interest rates throughout this year, chances are you will have better opportunities later this year to get higher, shorter-term investments. In addition if you buy those longer-term securities now, as the Fed raises rates, you will see the market value of those investments dropping (another good indication that you may be missing out on higher yielding investments).
One investment option available for most public funds investors is the government agency discount note. It is very similar to a Treasury bill, but is issued by one of the government agencies (e.g., Federal Home Loan Bank). The maturity dates on these securities range from overnight (similar to a repurchase agreement—but no collateral requirements) to one year.
There are many benefits to owning this type of investment, especially in this type of interest rate environment. They are highly liquid securities and offer some of the best short-term yields. There are significant amounts of these investments being traded in all maturities on any given day. You have the ability to sell out of these investments very easily prior to maturity, locking in your income earned, and then reinvesting in higher yielding investments as rates rise. These securities are used in a rising interest rate environment to add liquidity and flexibility to a portfolio, and to give investors the ability capture the higher interest rates.
PI: Can public investors (if their investment policy permits it) prudently invest in short-term securities abroad to obtain yield pick-up, without exposure to currency risk? Do you have any clients carrying out this strategy?
Chandler: Securities that are denominated in foreign currency necessarily entail exposure to currency risk. Minimizing the currency risk requires sophisticated hedging strategies that must be implemented precisely and monitored carefully. Most public investors do not have the time and resources necessary to implement hedging strategies. Furthermore, the cost of perfect or near-perfect hedges generally eliminates the yield advantage that foreign securities may appear to have. We do not have any clients carrying out this strategy.
Seasongood: Most public funds investors are extremely risk averse, so foreign securities are not typically an asset class used by them. In general terms, if an investor was looking to invest abroad, there are dollar-denominated foreign securities that could eliminate the currency risk. Given other factors including political and accounting related risks, only the most knowledgeable and sophisticated public funds investors should be considering this arena. Most public entities would probably not have the resources or the risk profile to invest in these types of securities.
PI: Are there new investment instruments that have emerged in the past few years that can be prudently used by public investors, or that they should be cautious about?
Chandler: Any strategies that promise more return than the typical, “plain-vanilla” securities that governmental entities usually invest in should be approached with great caution. Higher than “normal” returns are most often associated with higher than normal risk, although the risks may not be evident without thorough research.
Seasongood: While not necessarily a new investment instrument, the low interest rate environment has fueled the supply of agency “step-up” notes. Issued primarily by government agencies, the coupon rate for a step-up note is fixed for a period and then increases at predetermined intervals. The bonds are callable, though, so investors might not end up realizing the higher coupons.
Step-ups can prudently be added into a portfolio of investments. However, investors must compare the merits of a step-up to a callable agency note with a similar maturity. (See the November 2004 edition of Public Investor for more information on step-up securities).
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