April 3, 2017
Ever since the November 2016 election results, bonds have been under considerable scrutiny. The likelihood for higher interest rates, coupled with expected stimulus stemming from the new administration’s proposed policy agenda, triggered a reflation trade across the markets. As a result, the yield curve steepened, while equities rallied and investors priced in optimistic scenarios for U.S. stocks. We know “bond math” teaches us that rising rates drives bond prices down. Conventional wisdom might suggest that investors lighten their exposure to bonds in a rising rate environment, although such thinking would overlook the critical role that fixed income plays in a diversified portfolio.
Consider a typical 60/40 portfolio, which in recent years has evolved to better resemble a 70/30 mix of equities to bonds, given the appreciation in equities. It is not unusual for a balanced portfolio today to hold a meaningful percentage, at least 20%, of investment grade bonds, with the balance held in other bond-like instruments. If there are no material changes to an investor’s personal financial objectives, many may be rethinking their fixed income allocations, particularly in light of the new backdrop. Before making any changes, it might be wise for investors to review why they are invested in fixed income in the first place.
Portfolio ballast against market stress
In the portfolio construction calculus of Fiduciary Trust, high-quality bonds serve two basic functions: a) they produce income, and b) they provide a very important ballast against negative market surprises. That’s all. These allocations, for us, are not about making speculative total return plays. They’re also not about finding distressed turnaround opportunities. And, finally, in no way are allocations about making opaque currency bets. Those plays are reserved for other fixed-income satellite investments such as high yield, international currency investments, and distressed bonds. High-grade fixed income, in our philosophy, is a hedge against market disasters. These types of bonds can provide ballast against potential negative surprises that drive widespread selloffs across equities of all types. Under stress, non-investment grade bonds can assume equity-like characteristics and post losses similar in magnitude to stocks. Ballast fixed income tends to counteract such market forces, and is the destination for investors seeking quality in panics.
If all bonds are not created equal, then it’s important to determine which types of bonds provide ballast. Look no further than the financial crisis of 2008. The chart below (Exhibit A) highlights a range of asset classes and their performance during 2008. It clearly demonstrates that high-quality fixed income in various classifications had positive returns in a year when many other asset classes suffered substantial losses.
It is important to acknowledge that there are other asset classes that posted positive returns in 2008. Timber is one example. However, high-quality bonds like Treasuries and corporate investment grade bonds are generally considered to be more attractive during times of panic given their transparency, accessibility to all investors, and liquidity profile. Moreover, their track record during past bouts of economic and market unrest reinforces their role as ballast. Going back as far as 1928, the S&P 500 has posted double-digit negative annual returns 10 times; in all but two of those years, the 10-year U.S. Treasury ended the year in positive territory, while the three-month T-Bill posted positive returns in each of the 10 years (Exhibit B). Other asset classes did not hold up as well.
Other more striking examples demonstrate the durability of U.S. Treasuries in times of stress. In 2011, Standard & Poor’s ratings agency downgraded U.S. Treasuries to AA+ from AAA, simultaneously placing them on “negative outlook.” The news of this action – coming as a shock to investors worldwide – took place after the markets closed on a Friday evening in August. It was anticipated that the following Monday would see a tremendous selloff in Treasuries. Instead, Treasuries rallied. By the end of the week, remarkably, the 10-year Treasury price actually increased as yields dropped from 2.50% to 2.25 percent. The point of this: even when faced with what was considered to be a worst-case scenario for Treasuries, it is ironic that investors still sought refuge in the very instrument that was the cause for concern.
When rates rise, don’t lose focus
Most investors seek portfolios that generate some amount of steady income. If you are committed to a long-term investment horizon, bonds should play a crucial role of providing income. And if you remain patient, a rate increase can lead to higher bond returns over time through higher income.
While high-grade bonds should anchor allocations to protect against the unexpected, that doesn’t mean they are invulnerable to a rising rate scenario. When market conditions are absent of selloffs or panics, investors may overlook bonds’ ballast properties. Instead they may focus on rising rates and the short-term ‘paper losses’ in their portfolios, since bond prices decrease as interest rates increase. However, there are still reasons to hold bonds, especially in a rising rate period.
Many investors are surprised to learn that not all fixed income responds the same to higher rates. For example, Exhibit C1 shows how a range of fixed income instruments has performed in recent periods of rising interest rates. Here we chose periods in the last 15 years where the 10-year Treasury yield rose at least about 50% within one year. In the table, the Corporate Investment Grade, U.S. Aggregate, and Municipal -columns represent high-quality bond indices. We have also included floating rate loans and high yield indices as two examples of fixed income satellites.
Across bonds, the effect of rising interest rates runs along a spectrum, and the impact on prices can either be more pronounced or negligible depending on the types of bonds. As expected, during periods of increasing interest rates, higher quality bonds do experience price pressure. But, notice how the satellite asset classes in fixed income historically offset the traditional negative responses to higher rates. This is most likely because high-yield bonds’ higher coupons or floating rate loans’ adjustable rates can offset price declines in principal, yielding positive returns in many cases. This property can potentially mitigate the impact of future rising rates to portfolios.
It is important to examine the performance of the various types of bonds after the rate increases occurred. Exhibit C2 shows how the same bonds of different types have recovered in the year following the sharp rise in rates.
What this shows is that staying fully invested in bonds allowed the higher rates to generate greater current income, which in turn, offset the price erosion to various degrees. For example, investors who remained invested through the rate hike cycle from February to June 2015 would have been pleased: all five bond types for the one-year period after the rising rate cycle displayed positive returns. This means that investors may benefit from higher, not lower rates over time as the compounding effect of the coupon income begins to dominate the return calculation.
Regarding portfolio construction, 20% to 35% total allocations to fixed income, investment grade bonds, and Treasuries may typically comprise the bulk of the commitment. In addition, smaller “satellite” investments in bank loan funds, high yield debt, or other fixed income securities can complement an individual’s core bond holdings as the environment changes. This allows us to fine tune and customize portfolios based on clients’ income needs, return expectations, risk appetites and investment time horizons as well as other, market-related factors.
The U.S. has experienced quite a run of positive economic news, including fourth-quarter S&P 500 corporate earnings that increased both sequentially and year over year, and improving consumer sentiment. The positive momentum continues, in spite of considerable domestic and global uncertainty. Given the Fed’s recent rate hike actions, many investors will be wrongly focused on exiting fixed income as the economy most likely continues to improve. Among the “known” unknowns in 2017 are the upcoming elections and referendums throughout the Eurozone, fallout from last month’s National People’s Congress in China, and the ongoing presidential transition in the U.S., all of which will surely influence capital markets. Along the way, the six remaining FOMC meetings will also be closely watched by analysts who are anticipating anywhere from two to three rate hikes in 2017.
As investors struggle to comprehend the new policies of President Trump as well as a global macro-economic picture that offers little conviction, some may continue to second-guess their original portfolio construction and asset allocations. To the greatest extent possible, important decisions about changing the policy allocations must be centered on facts and observations. The present conditions are so fluid that there aren’t enough clear signals in the noise to conclude that the time is right to reduce one’s bond exposure. Ironically, that’s a main reason to remain respectful of high-quality fixed-income and to ultimately stay the course. Should there be a surprise around the next turn, investors will be thankful for the stability provided by their fixed income ballast.
The opinions expressed in this article are as of the date issued and subject to change at any time. Nothing contained herein is intended to constitute investment, legal, tax or accounting advice, and clients should discuss any proposed arrangement or transaction with their investment, legal or tax advisers.