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In Deep Dive #004: Fixed Income in Focus, Correspondent Research Analyst Ross Mayfield discusses the full spectrum of fixed income considerations: why and how to own, the current rate environment, and what we like moving forward.
A Bad Day in Stocks
A wise investor once opined that “a bad day in stocks is a bad year in bonds.” This expression quickly gets at the heart of why we own bonds: safety, steady income, and diversification. But fixed income has been challenged this decade. Following the financial crisis, central banks slashed lending rates in a coordinated effort to stimulate the world economy. As a result, the Fed Funds rate hovered around 0% for years; Treasuries didn’t yield enough to keep up with inflation, much less to fund a retirement. Simultaneously, the threat of rising rates loomed large. This prompted some investors to reach for yield by extending duration and/or lowering credit quality, both of which threaten to erode the safety that fixed income promises.
Though many are still grappling with recent policy’s long-term effects, the Fed has finally begun to normalize rates. This will hurt prices near-term, but we view this trade-off as short-term pain for a long-term gain. Initial yield tends to be an accurate predictor of total return, so as rates reset higher and coupons rise, the picture becomes much rosier for bond investors.
Further, we believe that fixed income belongs in many investor portfolios. While the type, duration, quality, and overall weighting will vary based on the individual, fixed income is a strong portfolio diversifier. In addition, the capital preservation and steady income properties are critical for investors nearing or enjoying retirement.
Back to our wise investor: The chart at right displays the number of down days by magnitude over the last decade for stocks vs. bonds (the Barclays Aggregate, or Barclays Agg, represents the Bloomberg Barclays US Aggregate Bond Index, an index of investment-grade, USD-denominated, taxable bonds). Put simply, bonds may not be exciting, but their safety and stability can be vital.
Why Own Fixed Income?
If an investor buys a bond, assuming the issuer doesn’t go bankrupt, the investor will receive their principal back at maturity (plus interest earned along the way). Equities, on the other hand, have zero guarantees and no maturity date. The price you get for your stock is only the highest price that another investor is willing to pay for it. Additionally, in the somewhat rare event of a bankruptcy, bondholders are paid before preferred and common stockholders. For retirees, this safety is paramount.
To many investors the most appealing feature of fixed income is, well, the income. In this arena, rising rates are a welcomed development. Despite the drop in yields since the crisis, the 2-yr Treasury is still currently yielding over 100 bps more than the S&P 500, 2.90% to 1.85%. This is nearly an all-time low for the dividend yield on the S&P 500. The saying goes “play the hand you’re dealt.” While bond yields are still low in a historical context, income-needy investors can get almost 3% from a short-term, risk-free security, while maintaining the flexibility to roll forward if/when rates move higher.
Fixed income remains one of the best diversifiers for equity exposure available. Since WWII, there has only been one year when the S&P 500 and 10-year Treasury were both negative. Similarly, since 2000 both the Barclays Agg and the S&P 500 have been positive, but display a -0.15 correlation. Both generate inflation-adjusted, positive returns over the long haul but follow different paths to get there, providing complementary return streams and smoothing overall portfolio returns.
However, as you can see in the chart below, this effect is limited to certain types of bonds—generally safer, higher credit quality offerings. This diversifying effect is even stronger in equity market drawdowns. In years where the S&P 500 has lost over 9%, 10-yr Treasuries return over 6% on average. Finally, diversification is key to a strong rebalancing strategy. Having high quality, liquid fixed income allows you to take gains and buy stocks at a discount during pullbacks.
The Behavioral Factor
Everyone is a model investor until they’re staring down a bear market and a statement dotted with red. A fixed income allocation smooths portfolio returns and can limit pain during the worst stock market drawdowns.
Investor behavior, in aggregate, is fairly poor. Analyzing fund data, JP Morgan notes that the average investor has seen just a 2.6% annual return over the past 20 years vs. 6.4% for a 60/40 portfolio. We are often our own worst enemy. For instance, over three years from 2000-2002, the S&P 500 sustained a slow, painful drawdown of ~38%. Selling to stop the bleeding would have been normal human behavior, especially in a third straight year of losses. Luckily, the Barclays Agg was up 34% over the same period. Adding fixed income to an equity portfolio makes for a smoother ride, reducing drawdowns and potentially limiting any panic selling.
The Current Environment
But do these reasons to own bonds still make sense? Though we are well into this rate hike cycle, it does pay to evaluate how various fixed income instruments performed during previous rate hike regimes. Over the past 20 years, the US has undergone just one sustained period of hikes, from 6/04-6/06. Over those two years, the Fed raised rates seventeen times. While this would seem negative for bonds, it was far from the case. Loans and high yield (aka HY bonds) performed best, but Treasuries, TIPS, and investment-grade (IG) also notched gains. In ‘05, the Fed raised rates at every single meeting, eight times total. That year, the S&P 500 was up 4.8%, but 3-mo T-bills and 10-yr T-bonds were up 3.0% and 2.9%, respectively.
A few lessons can be gained from prior rate hikes. Raising rates is a tool used by the Fed to temper a possibly overheating economy. As rates rise and the economy slows, default rates tend to go up and spreads widen, especially later in the cycle. Though high yield performed well during the mid-2000s, it had more mixed results in the few short hike cycles of the 1990s. Additionally, short-term debt tends to outperform during periods of rising rates; as the Fed hikes, lower duration bonds lose relatively less value. And because coupons generally reset higher along with a rising Federal Funds rate, short-term investors can roll their bonds forward into higher-coupon securities sooner.
Bonds Acting Like Bonds
In addition to rate hikes, bond owners also face credit risk. Investors generally want their bonds to act like bonds when they need them to. Unfortunately, sustained low rates over recent years have led investors to reach for yield in suspect areas. High yield bonds, preferred stocks, leveraged loans, etc. have all been in favor due to high yields, though these products act almost nothing like traditional fixed income.
In fact, high yield bonds tend to be much more highly correlated with equities than they are with Treasuries, especially in times of market stress. Be wary of equity-like bonds at this moment in time. See the price chart to the right, detailing a five-year window around the financial crisis. During flights to safety, high yield bonds are not spared. Additionally, default rates on high yield bonds tend to spike during recessions, throwing “capital preservation” to the wind. While high yield has less interest rate risk, the sector is very sensitive to the economy. In a similar vein, leveraged loans have become popular for their high yields and floating rate coupons. While this appeals to those struggling with both low rates and the current rising rate regime, these loans face outsized credit risk. The covenants on current loans are increasingly light, potentially resulting in poorer recovery rates in a downturn. Concurrently, the overall credit rating of the market is much worse than pre-crisis. This bears keeping in mind as we continue into one of the longest bull markets in modern history.
Even investment-grade (IG) deserves attention. Years of low rates fueled higher debt levels, but as rates rise it becomes increasingly difficult to pay down said debt. The percentage of BBB-rated debt (almost junk) in the IG universe is up significantly since the crisis, as displayed in the chart to the right. In the Russell 2000, almost 100% of IG debt is BBB. Certainly, increased diligence is warranted.
What To Do About It All?
As the Fed has raised rates, the spread between the 2- and 10-yr Treasury has narrowed drastically to 26 bps. As ISR sees two to three more hikes by end of year 2019, we believe the short end of the curve looks attractive, with now being a good opportunity to shorten the duration of your portfolio. This does two things: reduces your price exposure if the Fed raises rates, and allows you to roll your fixed income into higher yielding bonds sooner, rather than later. As seen below, a continued move upward in rates disproportionately hurts long duration bonds.
Simultaneously, we believe that rebalancing into higher-quality fixed income offerings could be timely. Aside from our discussion earlier about correlations in times of stress, we think that at this point in the cycle, investment-grade options higher in quality offer an intriguing value proposition. Should the economy slow as the Fed continues to normalize rates and fiscal stimulus fades, highly rated debt has the potential to outperform.
Finally, we believe that owning a diversified basket of bonds can help maximize risk-adjusted return and reduce cost over the long haul. For many investors, this means owning a fund. In this arena, it is important to note that the “passive” model has proven less robust in bonds than in stocks. The case for active management is strong: A large share of bond buyers’ motives aren’t necessarily to maximize returns, like those of central banks or insurance companies. This creates inefficiencies, allowing active managers to generate excess returns. Index funds can skew the market further. Bond ETFs are less tax efficient than their equity counterparts and most are weighted by the size of outstanding debt. This is a concern for two reasons:
- Broad indices like the Barclays Agg have allocated large weights to government debt following post-crisis policy acts. While this reduces default risk, it skews duration and yield. Instead of a general universe of US bonds, an investor gets a proxy for government debt. That said, in times of stress, overweighing Treasuries is generally profitable.
- This can also be a problem in corporates. More debt generally leads to a lower credit rating and an increased cost of borrowing. Over-levered firms are often hit the hardest in downturns, leading to larger losses and lower recovery rates. This is especially concerning in HY bonds, which are already on the lower-end of the credit quality spectrum.
Our views on fixed income are resolute. We believe bonds make sense for many investors, for any of the reasons detailed above: capital preservation of one’s nest egg, steady income for retirees, diversification of more volatile assets, or smoothing return streams during stressful times. Within fixed income, we think now is an opportune moment to shorten duration and increase the quality of bond holdings.
With equity volatility back and our economic recovery entering the later innings, it may an especially prescient time to revisit your bond holdings. To reiterate, fixed income may not be exciting, but its safety and stability are invaluable.
Investment Strategy & Research Department
- Mark Nickel, SVP, Chief Investment Officer | 502-588-1227 – email@example.com
- David Burks, SVP, Equity Income Analyst | 502-588-8648 – firstname.lastname@example.org
- Ross Mayfield, Correspondent Analyst | 502-585-8994 – email@example.com
- Spencer E Joyce, VP, CFA, Markets Analyst | 502-588-8402 – firstname.lastname@example.org
- Susan Koch, Communications Strategist | 502-588-1744 – email@example.com
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All investing involves risk, including the possible loss of principal. You should carefully consider investment objectives, risks, charges, and expenses of any investment before investing. Diversification and asset allocation do not guarantee a profit or guarantee against a loss.
Stock markets, especially foreign markets, are volatile and can decline significantly in response to adverse issuer, political, regulatory, market or economic developments. The bond market is also volatile, and fixed income securities carry interest rate risk. (As interest rates rise, bond prices usually fall, and vice versa. This effect can be more pronounced for longer-term securities.) Fixed income securities also carry inflation risk, liquidity risk, call risk, and credit and default risks.