Eugene Fama Photo

Eugene Fama's Contributions to Our Understanding of Fixed Income Investing

Eugene Fama Photo

Introduction

All too often, when we hear discussions of the intellectual contributions of Eugene Fama, a 2013 Nobel Laureate in economics, they are limited to the realm of stock prices. For example, in explaining market efficiency, the most commonly brought example is how the share price of a given company incorporates the most recent news about that company, as explained in this video.

Given that Fama’s seminal paper on market efficiency centered on stock prices, this focus is not unwarranted. Similarly, discussions about the risk factors identified by Fama and French usually center on the three factors related to stock prices, even though they fully expounded upon the factors that determine bond prices.   This article will outline the relevancy of Fama’s research to prudent fixed income investing, especially as it relates to market efficiency and priced risk factors.

Market Efficiency

In 1975, Fama published an article in The American Economic Review, “Short-Term Interest Rates as Predictors of Inflation”, in which he studied the relationship between current Treasury Bill rates (one to six months maturity) and forecasted inflation. Since at that time, there was no reliable way to measure forecasted inflation, Fama used actual inflation in the time period following the interest rate. Studies done prior to Fama’s had considered the current interest rate as a function of the inflation rate  of the same period, but this did not properly take into account the purpose with which the bond market sets prices, to compensate bond investors for bearing the risk of future inflation. Based on his regression analysis of the data, Fama concluded that the bond market is indeed efficient in setting the interest rates on Treasury Bills since those rates summarize all the information about future rates of inflation that is contained in the time series of past rates. Fama found that the additional return above the forecasted inflation (the real rate of interest) was essentially constant during the time period studied.

Nowadays, we can measure both the market’s forecast of inflation (to a fair approximation) as well as the real rate of interest by looking at yields on Treasury Inflation-Protected Securities (TIPS) and comparing to nominal Treasury securities. As of October 29th, 2013, the yield on the five-year TIPS bond is negative, meaning that a buyer is essentially guaranteed to lose purchasing power over the life of the bond.

Fama’s conclusion that the real rate of interest is determined by the market and not set by the Federal Reserve was controversial at that time and remains so to this day. Fama himself gives a humorous recounting:

There was a full day seminar on my paper at MIT, where my simple result was heatedly attacked. I argued that I didn't know what the fuss was about, since the risk premium component of the cost of capital is surely more important than the riskfree real rate, and it seems unlikely that monetary and fiscal actions can fine tune the risk premium. I don't know if I won the debate, but it was followed by a tennis tournament, and I think I did win that.

Regarding the role of the Federal Reserve in the determination of interest rates, Fama published a working paper1 in which he concluded that the data is inconclusive on the role of the Fed versus market forces in the long-term path of interest rates. In other words, although it may externally appear to us that the Fed has control over interest rates, the Fed may, in fact, simply be responding to the market’s determination of where interest rates should be. We will never know for certain. In a recent interview in InvestmentNews, however, Fama made his own position quite clear when he quipped, “I don’t think the Fed has any role in how high rates are right now. I don’t understand why everyone is paying attention to this tapering. The Fed is using one kind of bond to buy another kind of bond. What’s the big deal, and why is anyone taking the Fed seriously?”

Risk Factors that Determine Bond Prices

Since the market sets bond prices so that investors are compensated appropriately for the risk they bear, we could ask what are the risk factors that go into bond prices? Fama and French definitively answered this question in 1993 when they identified the two factors of term and default risk. Default risk is quite easy to understand—the more likely a bond is to default, the higher the expected return should be for the bond holder. Term risk can be thought of as payment for agreeing to bear the risk that interest rates may increase before the bond matures. An investor who agrees to bear this risk for a longer period of time should receive more compensation. While this is usually the case, there are occasionally periods of time where the opposite is true. This is what we call an inverted yield curve. One other important point about term risk is its diminishing marginal return. The majority of the benefit of taking on term risk can be found at five years of maturity. Going past five years increases the risk (standard deviation) without commensurately increasing the return, as shown below.

 

The Role of Bonds in a Balanced Portfolio

The risk of a balanced portfolio is best taken in the equity portion, and the role of fixed income is to reduce the risk to the client’s risk capacity and to provide a source of liquidity. Thus, the fixed income utilized by IFA is high quality and short duration. Another important finding of Fama’s on short-term fixed income is its role as a hedge against inflation. The very first fixed income fund offered by Dimensional Fund Advisors, the DFA One Year Fixed Income Portfolio, was originally named by Fama as the DFA Inflation-Hedged portfolio. This name remains evident in its ticker symbol of DFIHX. Fama designed DFA’s global bond funds to maximize the benefits of diversification while minimizing volatility by hedging foreign currency exposure. This makes them ideal companions for equity funds in a balanced portfolio.

Fama’s Approach to Constructing Bond Funds

All of the DFA fixed income funds that IFA advises for our clients utilize a yield curve strategy devised by Fama. Based on the assumption that today’s yield curve is the best predictor of tomorrow’s yield curve, there is an optimal maturity at which to buy bonds which are then held until they reach the optimal selling maturity. For example, in a five-year bond fund, the strategy may dictate buying bonds that mature in four years and selling them once they are three years away from maturity. Although this may sound like an active strategy, since it is completely rules-based, we regard it as passive.

Conclusion

As we stated in our prior article on Fama’s winning of the Nobel Prize, none of us would be where we are today without him. His work touches on all aspects of prudent investing and is certainly not limited to one asset class.


1Fama, Eugene F., Does the Fed Control Interest Rates? (June 29, 2013). The Review of Asset Pricing Studies, Forthcoming; Chicago Booth Research Paper No. 12-23; Fama-Miller Working Paper. Available at SSRN: http://ssrn.com/abstract=2124039.