Magnified risks from an uncertain term premium

The bi-annual releases of the IMF WEO and Financial Stability reports are so full of information that a lot of it ends up getting missed.  To be sure, way too much time is spent on the growth forecasts, which are out of date by the time they are published, largely because these documents are so big.

One interesting topic that came up in the Financial Stability Review for those interested in bond markets is that of rising interest rate risk.

Since the height of the financial crisis in 2008, there has been an explosion in holdings of bonds by mutual funds.  Financial repression by central banks has meant the chase for yield has been intense, with poor growth also pushing funds into debt rather than equities.

Not only has cumulative holdings of debt expanded much faster than the pre-crisis trend, but the average duration of bonds held has also increased as well.

This increases the sensitivity of the portfolio to movements in interest rates.  The IMF has estimated that the increase in duration of US bonds held means that investors will loose an extra 0.7% compared to previous periods of rising interest rates if we saw a 100bps rise in the US Bond Aggregate index.

That does sound like much, but consider that the total value of these bonds outstanding is 3 times larger in previous periods of tightening.

A further issue is that a big driver of the decline in bond yields since 2008 has not only been the change in actual and expected short rates, but also to a big change in the term premium.  This is basically the yield over and above expected short term rates that a borrower will have to pay due to risk.

The IMF has attempted to decompose what has driven the change in the term premium on US 10yr Treasuries, with expectations on QE and market uncertainty the big drivers of the decline, in their view.

This chart is to March 2013 and clearly we have seen a big increase in 10 year yields since then. This was partly due to a small shift in expected short rates, although this has now largely unwound.  But the bigger driver seems to be from the change in the term premium.

Policy makers would apparently have some control over this given expectations on the size of the Fed's balance sheet is deemed important.  And perhaps the decision not to taper has made a difference here. That said, its hard to see that the small reduction in purchases that has been delayed really tipping the balance that much.

So perhaps the bigger problem is the part policy makers can't control. And this has become increasingly big, with risk to portfolios increasingly magnified.

This is unlikely to create a major catastrophe on its own.  But could be an additional problem is other issues escalate.