1
• Does a longer time period reveal a different return-risk relationship?
• Historically, there has been no pay-off from duration extension– Intermediate Treasuries have had returns similar to long
Treasuries
• There has also been no pay-off to investing in credit– Long corporates have had returns similar to intermediate and long
Treasuries
0%
2%
4%
6%
8%
10%
12%
0% 2% 4% 6% 8% 10% 12% 14% 16%
Annualized Standard Deviation Of Return
Co
mp
ou
nd
An
nu
al R
etu
rn
One MonthTreasury Bill
IntermediateTreasury
LongTreasury
LongCorporate
S&P 500
Source: Ibbotson Associates
………………………
No duration pay-off
No credit pay-off
…….
Historic Return and RiskDecember 1959 to December 2002
2
Fixed Income Investment ChoicesDecember 1988 to December 2002
• For some investors cash is the “safe” asset
• A look at historical return and risk suggests two fixed income conclusions– Investment grade bond returns have been essentially the same, and– Fixed income investors have only had one choice to make
• How much return volatility to take
0%
2%
4%
6%
8%
10%
12%
0.0% 1.0% 2.0% 3.0% 4.0% 5.0%
Risk (Annualized Standard Deviation Of Return )
Ann
ulai
zed
Com
poun
d R
etur
n(1
2/88
to P
rese
nt)
Treasury BillLehmanMBS
LehmanAggregate
LehmanGovernment
Lehman Credit
Note: Lehman duration data begin Dec. 1988.
3
Is Yield the Best Predictor of Future Return?Average Credit Ratings And YieldDecember 1988 to December 2002
0.00%
5.00%
10.00%
15.00%
20.00%
Average Credit Rating
Ave
rage
Yie
ld
AAA AA A BBB BB B C
Credit C
Credit B
Credit BBCredit
BBBCredit
ACredit
AA
CreditAAA
USGovernment
MBS
• Many investors believe that, in the long-run, higher yield should translate into higher return• Typically, higher yield is associated with higher credit risk• Credit losses, though, may diminish a yield advantage• Have higher yields translated into higher return?
Source: Merrill Indices, Bloomberg
4
3.00%
4.00%
5.00%
6.00%
7.00%
8.00%
9.00%
10.00%
Average Credit Rating
Com
pound A
nnual
Ret
urn
AAA AA A BBB BB B C
Credit C
Credit B
Credit BB
CreditBBB
CreditA
CreditAA
CreditAAA
USGovernment
MBS
Is Yield the Best Predictor of Future Return?Average Credit Ratings And YieldDecember 1988 to December 2002
• Historically, investors have had a hard time forecasting credit losses• As a result, higher yield has not been a source of higher return
– Rather it has been a source of opportunity cost
Source: Merrill Indices, Bloomberg
5
Historical Pay-Off to Sector DiversificationDecember 1988 to December 2002
• For many investors, the government sector is the “safe” fixed income sector
• Historically, the credit sector has had the same return as 5-7 years Government bonds
• Historically, the mortgage sector has had:– Return volatility similar to three year governments, and– Outperformed comparable duration governments by about 50 basis points per annum
4.0%
5.0%
6.0%
7.0%
8.0%
9.0%
10.0%
0.0% 1.0% 2.0% 3.0% 4.0% 5.0% 6.0% 7.0% 8.0% 9.0%
Annualized Volatility
Ave
rag
e R
etu
rn
Three Month Treasury Bill
Lehman US MBS
LehmanAggregate
US Government
US Credit
US Government 1-3 Years
US Government 3-5 Years
US Government 5-7 YearsUS Government 7-10 Years
US Government 10+ Years
US High Yield
6
Historic Return And RiskDecember 1925 to March 2003
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0%
2%
4%
6%
8%
10%
12%
0% 2% 4% 6% 8% 10% 12% 14% 16% 18% 20%
Annualized Standard Deviation Of Return
Co
mp
ou
nd
An
nu
al R
etu
rn
One MonthTreasury Bill
IntermediateTreasury Long
Treasury
LongCorporate
S&P 500
………………………
No duration pay-off
No credit pay-off
…….
Inflation
7
• Does a longer time period reveal a different return-risk relationship?
• Historically, there has been no pay-off from duration extension– Intermediate Treasuries have had returns similar to long
Treasuries
• There has also been no pay-off to investing in credit– Long corporates have had returns similar to intermediate and long
Treasuries
0%
2%
4%
6%
8%
10%
12%
0% 2% 4% 6% 8% 10% 12% 14% 16%
Annualized Standard Deviation Of Return
Co
mp
ou
nd
An
nu
al R
etu
rn
One MonthTreasury Bill
IntermediateTreasury
LongTreasury
LongCorporate
S&P 500
Source: Ibbotson Associates
………………………
No duration pay-off
No credit pay-off
…….
Inflation
Historic Return And RiskDecember 1959 to March 2003
8
Historical Return And RiskDecember 1925 to March 2003
-40.0%
-20.0%
0.0%
20.0%
40.0%
60.0%
80.0%
0.0% 5.0% 10.0% 15.0% 20.0% 25.0%
Annualized Standard Deviation Of Real Return
Co
mp
ou
nd
An
nu
aliz
ed
Re
al R
etu
rn
Above Average Equity Return Below Average Equity Return Average
One MonthTreasury Bill
IntermediateTreasury
LongCorporate
LongTreasury
S&P 500
Note: Data source Ibbotson Associates. Methodology: create two vectors of real returns conditional on the contemporaneous real return of the S&P 500. One vector represents asset returns when the stock market real return is above average, the other represents returns when equity real returns are below average.
9
Historical Return And RiskDecember 1925 to March 2003
-4.0%
-2.0%
0.0%
2.0%
4.0%
6.0%
8.0%
10.0%
0.0% 1.0% 2.0% 3.0% 4.0% 5.0% 6.0% 7.0% 8.0% 9.0%
Annualized Standard Deviation Of Real Return
Co
mp
ou
nd
An
nu
aliz
ed
Re
al R
etu
rn
Above Average Equity Return Below Average Equity Return Average
One MonthTreasury Bill
IntermediateTreasury
LongCorporate
LongTreasury
Note: Data source Ibbotson Associates. Methodology: create two vectors of real returns conditional on the contemporaneous real return of the S&P 500. One vector represents asset returns when the stock market real return is above average, the other represents returns when equity real returns are below average.
10
Historical Return And RiskDecember 1925 to March 2003
-6.0%
-4.0%
-2.0%
0.0%
2.0%
4.0%
6.0%
8.0%
10.0%
12.0%
0.0% 5.0% 10.0% 15.0% 20.0% 25.0% 30.0% 35.0%
Annualized Standard Deviation Of Real Return
Co
mp
ou
nd
An
nu
aliz
ed
Re
al R
etu
rn
NBER Expansion NBER Contraction Average
One MonthTreasury Bill
IntermediateTreasury
LongCorporate
LongTreasury
S&P 500
Note: Data source Ibbotson Associates. Methodology: create two vectors of real returns conditional on the contemporaneous real return of the S&P 500. One vector represents asset returns when the stock market real return is above average, the other represents returns when equity real returns are below average.
11
Historical Treasury Returns When Treasury Index Rates Rise Or FallContemporaneous, December 1988 to April 2003
-15.0%
-10.0%
-5.0%
0.0%
5.0%
10.0%
15.0%
20.0%
25.0%
30.0%
35.0%
0.0% 1.0% 2.0% 3.0% 4.0% 5.0% 6.0% 7.0% 8.0% 9.0%
Annualized Standard Deviation Of Return
Co
mp
ou
nd
An
nu
aliz
ed
Re
turn
Historical Rates Rise Rates Fall
12
Historical Treasury Returns After Treasury Index Rates Rise Or FallOne Month Lag, December 1988 to April 2003
0.0%
2.0%
4.0%
6.0%
8.0%
10.0%
12.0%
14.0%
0.0% 1.0% 2.0% 3.0% 4.0% 5.0% 6.0% 7.0% 8.0% 9.0%
Annualized Standard Deviation Of Return
Co
mp
ou
nd
An
nu
aliz
ed
Re
turn
Historical Rates Rise Rates Fall
13
Historical Returns After Treasury Index Rates Rise One Month Lag, December 1988 to April 2003
-8.00%
-6.00%
-4.00%
-2.00%
0.00%
2.00%
4.00%
6.00%
An
nu
aliz
ed
Co
mp
ou
nd
Re
turn
Dif
fere
nc
e
14
Historical Returns After Treasury Index Rates Rise One Month Lag, December 1988 to April 2003 Return In Excess Of T-Bill
-8.00%
-6.00%
-4.00%
-2.00%
0.00%
2.00%
4.00%
6.00%
An
nu
aliz
ed
Co
mp
ou
nd
Re
turn
Dif
fere
nc
e
15
Historical Returns NBER Expansion/RecessionContemporaneous, December 1988 to April 2003Return In Excess Of T-Bill
-5.00%
-4.00%
-3.00%
-2.00%
-1.00%
0.00%
1.00%
2.00%
3.00%
4.00%
An
nu
aliz
ed
Co
mp
ou
nd
Re
turn
Dif
fere
nc
e
17
Historical Returns Positive Yield CurveOne Month Lag, December 1988 to April 2003Return In Excess Of T-Bill
-5.00%
0.00%
5.00%
10.00%
15.00%
20.00%
25.00%
An
nu
aliz
ed
Co
mp
ou
nd
Re
turn
Dif
fere
nc
e
18
Historical Returns Yield Curve Above In Sample AverageOne Month Lag, December 1988 to April 2003Return In Excess Of T-Bill
-5.00%
0.00%
5.00%
10.00%
15.00%
20.00%
25.00%
30.00%
An
nu
aliz
ed
Co
mp
ou
nd
Re
turn
Dif
fere
nc
e
19
Historical Returns Yield Curve Above Trailing Twelve Month AverageOne Month Lag, December 1988 to April 2003Return In Excess Of T-Bill
-6.00%
-5.00%
-4.00%
-3.00%
-2.00%
-1.00%
0.00%
1.00%
An
nu
aliz
ed
Co
mp
ou
nd
Re
turn
Dif
fere
nc
e
20
Historical Returns Five Year CMT Rates RiseOne Month Lag, December 1988 to April 2003Return In Excess Of T-Bill
-5.00%
-4.00%
-3.00%
-2.00%
-1.00%
0.00%
1.00%
An
nu
aliz
ed
Co
mp
ou
nd
Re
turn
Dif
fere
nc
e
21
Historical Returns Three Month CMT Rates RiseOne Month Lag, December 1988 to April 2003Return In Excess Of T-Bill
-7.00%
-6.00%
-5.00%
-4.00%
-3.00%
-2.00%
-1.00%
0.00%
An
nu
aliz
ed
Co
mp
ou
nd
Re
turn
Dif
fere
nc
e
22
Historical Returns Three Month CMT Above One Year AverageOne Month Lag, December 1988 to April 2003Return In Excess Of T-Bill
-10.00%
-8.00%
-6.00%
-4.00%
-2.00%
0.00%
2.00%
4.00%
An
nu
aliz
ed
Co
mp
ou
nd
Re
turn
Dif
fere
nc
e
23
Historical Returns S&P 500 Returns PositiveOne Month Lag, December 1988 to April 2003Return In Excess Of T-Bill
-15.00%
-10.00%
-5.00%
0.00%
5.00%
10.00%
15.00%
20.00%
25.00%
30.00%
35.00%
An
nu
aliz
ed
Co
mp
ou
nd
Re
turn
Dif
fere
nc
e
24
Historical Returns S&P 500 PE Above One Year AverageOne Month Lag, December 1988 to April 2003Return In Excess Of T-Bill
-8.00%
-6.00%
-4.00%
-2.00%
0.00%
2.00%
4.00%
6.00%
An
nu
aliz
ed
Co
mp
ou
nd
Re
turn
Dif
fere
nc
e
25
Historical Returns BAA-AAA Spread Above One Year AverageOne Month Lag, December 1988 to April 2003Return In Excess Of T-Bill
-16.00%
-14.00%
-12.00%
-10.00%
-8.00%
-6.00%
-4.00%
-2.00%
0.00%
2.00%
An
nu
aliz
ed
Co
mp
ou
nd
Re
turn
Dif
fere
nc
e
26
Historical Returns BAA-AAA IncreaseOne Month Lag, December 1988 to April 2003Return In Excess Of T-Bill
-20.00%
-15.00%
-10.00%
-5.00%
0.00%
5.00%
An
nu
aliz
ed
Co
mp
ou
nd
Re
turn
Dif
fere
nc
e
27
Historical Returns Growth Outperforms ValueOne Month Lag, December 1988 to April 2003Return In Excess Of T-Bill
-4.00%
-2.00%
0.00%
2.00%
4.00%
6.00%
8.00%
10.00%
12.00%
An
nu
aliz
ed
Co
mp
ou
nd
Re
turn
Dif
fere
nc
e
28
Fixed Income Indices
Merill Treasury Merill Agency Merill CreditMnemonic Index Inception Mnemonic Index Inception Mnemonic Index InceptionG0Q0 Treasury Index Dec-77 G0P0 Agency Index Dec-77 C0A0 Credit Index Dec-72G1O2 1-3 Years Dec-75 G1P0 1-3 Years Dec-75 C1A0 1-3 Years Dec-75G2O2 3-5 Years Jan-72 G2P0 3-5 Years Dec-75 C2A0 3-5 Years Dec-75G3O2 5-7 Years Jan-72 G3P0 5-7 Years Dec-75 C3A0 5-7 Years Mar-90G4O2 7-10 Years Jan-72 G4P0 7-10 Years Dec-75 C4A0 7-10 Years Jun-92G7O2 10-15 Years Mar-76 G7P0 10-15 Years Dec-75 C7A0 10-15 Years Mar-76G8O2 15+ Years Mar-73 G8P0 15+ Years Dec-75 C8A0 15+ Years Dec-72
C6A0 5-10 Years Dec-72
Merill Credit Merrill Salomon CreditMnemonic Index Inception Mnemonic Index Inception Mnemonic Index InceptionC0A1 AAA Dec-88 D0A0 Aggregate Dec-75 SBCRP710 7-10 Years Dec-79C0A2 AA Dec-88 G0A0 Government Dec-72C0A3 A Dec-88 G0Q0 Treasury Index Dec-77C0A4 BBB Dec-88 G0P0 Agency Index Dec-77J0A1 BB Aug-88 C0A0 Credit Dec-72J0A2 B Aug-88 M0A0 MBS Dec-75J0A3 C Aug-88 R0A0 ABS Dec-90
J0A0 High Yield Oct-84IGOV Emerging Market Dec-91
29
• Claude,
I would like to concentrate on the graphs on pages 1, 2, 4, and 5.
Basically, we will cut the data into two buckets, A and B and graph the curves for these (on the same graph, i.e. there willbe two curves, sample A and sample B).
1. A=NBER recessions (Peak to Trough), B=NBER expansions (Trough to Peak) http://www.nber.org
All of the next graphs are predicitve. We observe a state and then take a position the next month.
2. Term structure inversions (5yr-3mo Treasury yield). A=Inversion (sample the month *after* inversion, i.e. if term structure inverts in Feb, March goes into A, if it returns to positive slope in September, A will include March-September, October will go to B. This way, we are operating on an ex ante basis.
3. Past changes in interest rate yields. A=month after US 5-yr increases, B=month after US 5yr decreases.
4. Same except use 90 day T-bill yield
5. The 90-day T-bill minus the 12month moving average of the Tbill yield. Positive is A, negative is B.
6. Last month's S&P 500 return, negative is A, positive is B.
7. S&P 500 P/E minus 12-month average P/E negative is A, positive is B.
8. Change in Moody's Baa-Aaa (on Federal reserve of St. Louis Website), negative is A, positive is B
9. Baa-Aaa minus 12-month moving average. Positive is A, negative is B.
10??? Value minus growth performance??? in previous month?
Add whatever your favorite indicator is.
-Cam