Investors have historically been attracted to bonds due to their steady return profile and relatively lower volatility compared to competing asset classes such as equities and alternatives. More than 20 years of gradually declining interest rates and narrowing spreads certainly helped investors achieve their objectives. Unfortunately, those days appear to be behind us.
Slow global growth coming out of the “Great Recession” in developed markets, coupled with a massive increase in global debt during this period, has likely brought an end to the secular fixed income bull market. Eventually, rates should rise, and when that occurs, the long-standing strategy of going long duration will have to change. Substantial bond purchases by global central banks have kept bond valuations afloat, at least for now. The resulting near zero-bound interest rates have impeded the opportunity to generate carry, an historically important source of return in fixed income portfolios. The persistently low rates found in developed market sovereign benchmarks have lowered the opportunity to capture carry by maturity extension.
At the same time, the growing possibility of rising interest rates means other components of carry, namely credit and volatility, may negatively impact portfolios. Volatility is of special concern as the market continuously assesses the frequency that the Federal Reserve (Fed) raises interest rates in 2016, with perhaps an increase as early as mid-June. Any divergence between Fed actions and market expectations could lead to turbulence similar to 2013’s “taper tantrum.” Bonds are also highly susceptible to liquidity concerns, an overlooked feature of carry. Constraints placed on banks’ historical roles as providers of liquidity in thinly traded bonds have magnified the risk of large price fluctuations and their associated impact on returns.
Another component of exceptionally accommodative monetary policy – low to negative interest rates – has exacerbated the challenges facing bond investors. Demographically, the timing could not be worse. Aging populations’ retirement savings in much of the developed world are seeing yields on their investments shrivel and are being put increasingly at risk of a capital loss. Pensions and endowments, along with segments of the financial services industry such as insurance providers, see their business models compromised as yields in their investable universe fall well short of those required to meet future obligations.
Historic Assumptions About Fixed Income Portfolios Should Be Reconsidered
Just as these business models have been disrupted, investors are questioning long-standing paradigms of how they manage their portfolios.
At Janus Capital, we believe investors should seriously consider freeing themselves from the constraints inherent in traditional benchmarks for a portion of their fixed income investments. For instance, the current duration risk imbedded in these indices exceeds the paltry return potential typified by today’s low yields.
The yields on longer-dated, and thus more interest-rate sensitive, bonds are at a level that any return achievable through income generation can be more than offset by only a slight rise in rates, with potentially devastating effects. Consequently, we feel investors would be wise to keep duration short. Shorter-dated securities of lower tiers of investment-grade corporate credit, along with choice quality high-yield credits can offer attractive risk-adjusted returns. Visibility, and thus confidence, in the near-term ability of these issuers to meet financial obligations can be achieved through diligent analysis, unlocking the potential for returns higher than the broader (index-driven) market affords them.
These securities also benefit from what we see as a structural inefficiency in fixed income markets. Their maturities of greater than one year exclude them from money market funds, yet they are too short-dated to be included in many indexed funds based upon major benchmarks such as the Barclays U.S. Aggregate Bond Index. This lack of investor focus can lead to an opportunity set capable of achieving steady returns in the roughly 2% range.
Still, the returns of these shorter-dated securities fall short of their historical norms. To attempt to make up the difference, investors can take advantage of the current environment by borrowing at low interest rates and judiciously applying mild leverage to portfolios. The introduction of leverage is not without risk, which is why it is important to select securities that have relatively low volatility in order to limit the potential of loss on these positions. For portfolios classified as diversified fixed income – or core plus – levered positions that raise the volatility of the entire portfolio into the 4% to 8% range may produce risk-adjusted returns more attuned to what fixed income investors have historically expected.
Volatility itself can be an attractive source of returns in a low-yield environment. A string of subpar earnings seasons and numerous sources of potential geopolitical risk have investors on edge. The tendency for investors to overpay for volatility protection is likely magnified in the current environment. A skilled investment manager can be rewarded by selling volatility protection on the securities, sectors and asset classes where market prices assume an excessive level of risk. Similarly, bond investors, fearful of potential defaults – a possibility aggravated by increasingly levered balance sheets – are often willing to overpay for default protection. Here too, this bias toward overpayment can become a source of return for managers who sell default protection in the form of credit default swaps.
Step Outside The Box
Given the low return profiles of traditional fixed income benchmarks, investors may be enticed to consider asset classes not included in these indices (i.e., beyond the benchmark). Lower-rated corporate debt, emerging market debt, foreign currency exposure and certain equities can provide investors with potential returns higher than those currently priced into fixed income benchmarks. This strategy has merits, but investors should exercise care when expanding their opportunity set.
A possible misstep is to simply replace duration risk with credit risk when including lower-rated corporate issuers. Another consequence is increasing the portfolio’s beta and raising its correlation to risk assets. Portfolios overly reliant on credit – especially high yield – to enhance returns merit special caution given that lower-quality securities often have higher levels of volatility than core fixed income instruments. Relying upon these instruments for returns can put an entire portfolio at risk, should volatility arise from an interest rate increase, a wave of corporate bankruptcies, a geopolitical event or recession. Each of these is within the realm of possibility over the coming quarters. The consequent spike in volatility and increased correlation with risk assets could rob a fixed income portfolio of two of its key characteristics: lower volatility and diversification away from riskier asset classes, (e.g., equities).
Rather than subjecting the portfolio to higher-beta directional trades in their quest to achieve historical fixed income returns, investors can harness these asset classes by including them as possible sources of volatility and default-protection sales.