Today’s post comes to you from Nick Follett, fixed income manager on our Investment Management and Research team.
Interest rates are near all-time lows, and the premium investors demand for assuming increasing risk above that of Treasuries isn’t, well, premium. So, if you’re not getting paid to hold bonds, is there still a case for them in your portfolio? The short answer is yes. The longer answer is that there are two main reasons: total return and diversification.
Yield Vs. Total Return
Historically, the income component of your bond portfolio provided 90 percent to 95 percent of the portfolio’s total return. Price appreciation accounted for the other 5 percent to 10 percent of the income attribution. Put another way, practically all you had to do to get the lion’s share of your return was to hold your bonds and clip coupons. Rates, as we know, are low and will most likely stay that way for quite some time. Currently, the yield on the benchmark index, the Bloomberg Barclays U.S. Aggregate Bond Index (commonly known as the “Agg”), is 1.15 percent. Even below-investment-grade bonds are currently yielding only 4.7 percent. But the total return for the Agg this year is 7.4 percent.
I understand that rates have fallen dramatically in 2020. Specifically, the rate for a 10-year Treasury went from 1.90 percent at the start of the year to 54 bps barely two months later. This fact highlights how we’re in a (new) new normal. Unless investors are willing to accept returns marginally above 1 percent, the price appreciation component of their return attribution must make up a bigger piece of the pie. We’ve been hearing from portfolio managers who have already moved in that direction. But, of course, it’s easy to say, “Buy low and sell higher.” In practice, achieving this feat isn’t simple. Without taking on greater risk, returns on bond portfolios in this environment will be lower than in prior years, regardless of how they’re derived.
A strategy focused on price appreciation depends on active managers with broad mandates to buy and sell. It’s not likely to work with passive investment vehicles that seek to replicate a benchmark. Investors looking for gain will have to seek out mispriced securities in some of the more esoteric investment sectors. To be clear, I’m not suggesting that investors take on excess risk. But let’s suppose the Agg is made up of 40 percent Treasuries, 30 percent corporate bonds, and 30 percent mortgages. Chances are good that this mix is perfectly priced, providing little to no opportunity to discover undervalued securities. Investors will be stuck with a total return based on yield rather than price appreciation.
A Simultaneous Sell-Off
In March, we saw the bond market break. Its usual correlation with the stock market went out the window, as equities, real estate, gold, and fixed income investments were sold off simultaneously. Let’s consider why this happened. The sell-off wasn’t due to a credit event such as those usually blamed when stocks and bonds retreat simultaneously. Instead, the bond market experienced a liquidity problem. Traders weren’t able to unload Treasury notes, which are considered the most liquid asset in the market. But, during the weeks that followed, the Fed’s incredible and unprecedented actions unfroze markets by literally rewriting the rulebook and purchasing nearly everything under the sun including, indirectly, equities. (See this interesting read about Apple buying its own stock with Fed money.) The markets were able to resume some sort of normality in a time when most things were anything but.
Back to Normal
Since then, the bond market has been performing as it should: negatively correlated to the stock market. In fact, since March 24 (the trading day after the Fed announced one of its purchasing programs), in the 13 times the S&P 500 has gained or lost more than 3 percent in a day, the 10-year Treasury moved in the opposite direction (or stayed flat) 11 of those times.
If you reduce the amount of volatility, the results are more striking. Of the 27 times the S&P gained or lost more than 2 percent in a day, the 10-year Treasury moved in the opposite direction (or stayed flat) 24 of those times. And the downside protection is even more drastic. All 6 times the S&P 500 closed 3 percent lower than the day before, bonds closed higher than the day before. And all 13 times the S&P closed 2 percent lower, bonds closed higher.
Value of Diversification
When you put those performance numbers together, they say the bond market provided diversification on volatile equity days almost 90 percent of the time. Furthermore, whenever the stock market sold off more than 2 percent, the fixed income portion of a diversified portfolio would have acted as a ballast and muted the loss. In other words, rumors of the demise of the value of a 60/40 portfolio allocation have been greatly exaggerated.
But, you may ask, does holding bonds on risk-on days generate suboptimal performance? Let’s look at what happened on the day after Pfizer announced its preliminary data showing that its COVID-19 vaccine was more than 90 percent effective. The three main equity indices (the S&P 500, the Dow, and the Nasdaq) hit new all-time intraday highs. The yield on the 10-year Treasury went up by 16 percent and, with the inverse correlation between bond yields and prices, fixed income sold off. Yes, holding bonds on epic risk-on days may make your performance suboptimal. But, over time, it may smooth out your portfolio’s ride dramatically.
The Case for Bonds
There are multiple reasons to hold fixed income apart from the income. There’s the total return performance that investors will be forced to rely upon more heavily. This strategy entails using active managers to seek out undervalued bonds. And there’s the diversification aspect. Despite the fact that bonds moved in concert with equities in the March rout, the underlying issues with the markets have been systematically addressed. Since then, bonds have been acting like bonds.
The Bloomberg Barclays U.S. Aggregate Bond index covers the U.S. investment-grade fixed rate bond market, with index components for government and corporate securities, mortgage pass-through securities, and asset-backed securities.
Bonds are subject to availability and market conditions; some have call features that may affect income. Bond prices and yields are inversely related: when the price goes up, the yield goes down, and vice versa. Market risk is a consideration if sold or redeemed prior to maturity.