Comparing Curves

As the Fed moved again on June 13th,  we thought we would share our thoughts on portfolio construction as it pertains to one’s fixed income allocation. At Ballast, we think about credit first (see this piece), and then, we move on to the curve. The below chart shows the treasury curve from June 13th (green line) compared to five years ago. So, today’s long bond (30-year) is the same yield as it was 5 years ago.  The 10-year as of today is just shy of 3%, whereas it was about 1.80% 5 years ago.


Treasury Curve May – June 2018

Source: Bloomberg

Why is all this important? 

The chart above shows that 5 years ago it was the Fed’s mission to get people to lend at all costs (aka- free money). You were paid to extend (steep slope to yield curve – orange line). This resulted in the unintended consequence of people lending or investing in items that may not have been a good asset for them.


This reminds us of Argentina.  One year ago, the market was ‘yield hungry’ – so hungry, that it has gobbled up $2.6 Billion of Argentinian debt at a 7.90 yield.  We remarked back then with surprise. Today, that bond is at $77.  So, although an investor clipped 7 points of interest, they have lost 13 points of principal.  We don’t have an opinion on Argentina and are simply citing its track record. This isn’t the opportunity for your capital.

What does this mean today?

It means that you get paid almost as much for lending 5 years as you do for 10 years. In bond jargon, we talk about ‘the roll’. The roll five years ago made sense – since when you buy a bond, you buy a coupon.  As that bond moves closer to maturity, [if the required yield from market is lower (steep slope) as you move shorter] there is price support provided.  This is unlike today, where you get no roll, so you would not extend maturity unless there were other reasons to do so.


So, as we construct portfolios, we continue to focus on the 3-5 year part of curve (thus limiting our duration while capturing yield).  If we had a strong bias of rising or falling rates, we could see ourselves adding or shortening duration, but at this time, it seems the Fed is on record for another 2 hikes this year – which will really flatten the curve.

Which means what?

Well, it means that the long end of the curve yields less than the short end of the curve.  Therefore, the long end is saying forward rates need to be lower – which some tend to associate with anticipating an economic slowdown.  The chart below shows the 10-year treasury versus the 2-year treasury. The top chart shows the 10-year yield (white line) and the 2-year treasury (orange line).  The bottom chart shows the yield difference.  Notice that the difference went below zero in early 2000s (preceded recession) as it did again in mid-2007 (another recession).  The recent trend seems to be heading toward zero,. Also, with market expectations of two more fed hikes, that takes Fed Funds to 2.25-2.5 % and the 2-year will move close (if not above) the 10-year.

2 – 10 Year Spread

Source: Bloomberg

What does this mean for our clients?

It means there is less incentive to lend money long term. They can capture yield in the front end without risking it for 10 years.


If the curve inverts,  it could indicate we are closing in on the end of one the longest economic cycles in recent times.  If that is the case, we look forward to clipping our coupons and being presented with many opportunities to choose from as risk assets re-price for the end of growth.

The ABCCC’s of Bond Investing

A bond’s total return comes from a number of factors, but the three largest are Coupon, Credit and Curve.  If you can remember these, you can help your chance of buying the right bond at the right time.

Coupon –

Coupon is the rate that the borrower agrees to pay you, and historically, it is the largest contributor to total return (See graph on Left).  The coupon on a bond is determined at the time the loan is originated.  Most bonds are issued with a fixed coupon.  This coupon defines the cash flow you receive over the life of the loan.  Since this coupon is set at the time the company issues the bond, the coupon reflects the credit worthiness of the company when it issued the bond.  Obviously, credit worthiness of companies improves or deteriorates over time – but the coupon doesn’t change (in some rare instances bonds have coupon steps where the coupon increases based on a rating agency’s rating, but these are few and far between).  Therefore, the way the market adjusts for any changes in a companies’ credit worthiness is through the price.  If a company was very credit worthy at the time of issuance but has declined in credit worthiness, an investor probably will expect a higher return (lower price) for that stream of future coupon payments.

Credit –

Credit refers to the ability to repay a loan.  Rating agencies have a rating system where the highest (most credit worthy) companies are triple A (Aaa  for Moodys and AAA for S&P & Fitch) and moves lower to AA, then A then BBB.  These ratings represent companies that have strong metrics in categories such as their business position, operating margins, leverage, management financial policy and whatnot.   If a company has a very strong ability to repay you, you would expect them to borrow at a lower rate versus a credit where repayment risk is higher.  The most credit worthy companies are grouped in a category called ‘investment grade’.  Less credit worthy borrowers are in a category called ‘high yield’.  High yield borrowers might have strong metrics in some categories, but they may have less credit worthy metrics in others.


This ‘C’ is the most important C of the bunch – since it doesn’t matter what your coupon is unless you have confidence your principal is being repaid.  The last thing you want is to generate 4% – 5% in income for 2 or 3 years – and then lose 50% of your capital.

Curve –

Curve refers to the length of maturity of the bond.  The treasury curve is usually positively sloped – which means that a borrower can expect to pay a higher rate if they want to borrow your money for a longer period of time.  The longer the maturity, the more time there is for something to go wrong with the company.  Therefore, when lending money for a long period, we prefer either to ‘move up in credit’ (which is lend to companies that have a bigger safety margin to their risk profile) or move down in price (find bonds that trade at steep discounts [see below] that mitigate the risk of principal loss but provide some upside opportunity).


This C is out of your control, and as treasury rates move (‘yield curve’), the price off the bond will move up and down.  However, our philosophy in Core Fixed Income is to buy bonds and hold until maturity. Therefore, we are less concerned with this factor as long as we get the right coupon and right credit.

What does all this mean?  For Ballast, it means a couple things:

  • Targeting Yield – We can control the yield on a portfolio by a number levers – a couple of which are ‘down in credit’ (1) lend to more risky companies or (2) ‘go out on the curve’ and buy a 10 year bond versus a 5 year bond. In either case, the yield is higher.  However, since at Ballast we control exactly what bonds go into a portfolio, we can solve for a number of different cash flow requirements.  Unlike a bond fund (which tends to own all the bonds in an index – or at a minimum tries to mirror that index), it ends up owning a lot of bonds that as a lender you likely would not have chosen.  For example, we had one client who transferred in a bond fund, and the fund owned a negative yielding bond.  We are not big believers in paying others to hold your money – regardless of what academic literature might say.
  • Finding Opportunity – Since credit quality changes over time AND a rating agencies’ ratings affect not only the price of bonds (borrower) but also the economics of those who own them (regulated investors like banks, insurance and index managers) – the price sometimes reflects other factors besides the credit worthiness of the issuer. For example, if a bond gets downgraded from investment grade (IG) to high yield (HY), it likely means that the corporation has become riskier due to some fundamental reason.  However, it also means that accounts that owned the bond when it was IG could be forced to liquidate, or they are charged more to hold that bond (risk based capital).  In both scenarios, you have what we call ‘forced selling’.  We believe – and research supports this belief – that forced selling presents opportunities.  Therefore, we constantly scour the capital markets for this type of situation. See Study here.

The three C’s of bonds are simple things to think about, but below the surface there is quite a bit that goes on. However, that is why finding an investment advisor with experience in the capital markets is valuable, and it can make a very big difference on one’s portfolio.