Opportunities and Challenges of the Modern Fixed Income Portfolio
Navigating the fixed income universe has proven challenging over the past decade. Treasury yields are low, making the need for alternative sources of return high in the asset class.
This is one reason why plan sponsors and advisors have adopted a growing and varied set of fixed income strategies in their portfolios. This diverse set of strategies offers higher return potential, but other risks (from lower credit quality and less liquidity, to increased volatility) are being introduced that would not be found through a simple allocation to a high-quality bond strategy.
What does that mean for fixed income investors today?
Fixed Income is Still a Valuable Portfolio Component
There are at least six reasons to be frustrated and cautious today with fixed income investments:
- corporate leverage,
- the state of liquidity/sponsorship,
- central bank balance sheets and subsequent influence on capital markets pricing,
- lackluster global growth and innovation,
- deteriorating creditor rights, and
- low developed market yields.
However, despite these current challenges, fixed income is still a worthy pillar of a diversified investment portfolio.
There are at least six reasons to continue allocating to the asset class:
- bond math versus equity “hope,”
- position in the capital stack relative to equities,
- ability to marry up structures (fixed rate, floating rate, securitized, callable, etc.),
- asset-liability management, and
- to capture value through differentiated risks and yields in a vast and growing global opportunity set.
The chart below illustrates the lower level of volatility that a blend of high quality bonds have exhibited versus stocks over time. It also addresses the first three of the six listed reasons to have fixed income.
There were meaningful benefits to this allocation in aggressive equity bear markets like 2002 and 2008, as well as a more recent year like 2018, where even though core bonds eked out only a small return, they held up far better than stocks did.
More modest performance swings and lower correlation to equity performance still make bonds attractive, despite the challenges they face.
Unlike common stock, bonds have numerous structures and unique characteristics for investors to analyze and ultimately implement a portfolio design around.
These attributes help plan sponsors further diversify risk, enhance returns, and manage liabilities. There’s a vast and growing $100 trillion global opportunity set for investors to sift through with an array of issuer types (sovereign entities, corporations, banks, etc.) and instruments to choose from.
Despite the growing presence of other less liquid, more volatile, and/or lower credit quality strategies, high-quality fixed income still has advantages and continues to fill the role that fixed income should provide to a plan. To be sure, high-quality bonds do face challenges, but that is a consequence of the economic environment in which we find ourselves, not a fundamental shift in the thesis or reason to abandon the allocation and assume benefits have disappeared.
The Bloomberg Barclays US Aggregate Index is a reflection of the domestic liquid investment grade universe. The following chart illustrates how the returns are broken out on a calendar-year basis between income and price.
Three out of the last six years were rising interest rate environments where the index experienced negative contribution to total return from bond price depreciation.
Even in those years, the income component of the index held up well. Clearly, income still exists and the two components will continue to work together and compound as they smooth out and enhance future returns.
Why Short-Duration Treasuries are Attractive
Many market participants believe this historic bull market for credit is getting long in the tooth. Unfortunately, there’s an opportunity cost to overemphasizing longer duration and high convexity assets because interest rates are currently flat and credit is expensive (said differently, spreads are tight).
At the end of March, the spread between 2-year and 10-year Treasuries was only 15 bps (yielding 2.27% and 2.42%, respectively). This low-yielding flat Treasury curve is support for a shorter duration fixed income strategy.
Pricing for shorter-term Treasuries is less distorted than the real growth and inflation pricing projection further out the curve.
Being Tactical at the Margin Doesn’t Always Mean Stretching for Yield
Prudently investing in higher-yielding spread sectors can be additive to an overall high quality fixed income portfolio.
However, yield for short-term Treasuries also appears to be more attractive now, and along with high quality short-duration credit, could help fixed income investors navigate through this environment.
As such, even with equity valuations continuing to climb in the late innings of the longest bull market on record, a variety of fixed income strategies still offer value.
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