Underappreciated, Often Maligned… But Still Critical: Why Continuing to Allocate to Core Fixed Income is Necessary

By Jason Staley, CFA

Over the past 12-18 months, we have alternatively described our outlook on fixed income as “less sanguine,” “not constructive,” “challenging,” and “unattractive,” among other less than optimistic portrayals. One phrase you have not heard from our team, however, despite our concerns about the fixed income asset class, is “abandon.” This is incredibly important because despite the challenges facing core fixed income — historically low bond yields and a U.S. Federal Reserve intent on raising interest rates, albeit in a deliberate and telegraphed policy — the asset class still offers investor portfolios two valuable characteristics: diversification and current income (lower than we would like, but cash flows nonetheless).

Applied Quantitative Research deconstructs the return of fixed income to its most rudimentary form: Total Return = Risk Free Rate + Excess Return1.   This formula essentially states that the return an investor can expect from fixed income is the interest rate on the 10-year U.S. Treasury Bond2, plus any risk premium associated with a bond (term, liquidity, and credit, among others) that could potentially deliver a return in excess of the risk free rate.  Taking the simple construct just laid out, an investor could reasonably make the judgment that they simply aren’t being compensated enough to own fixed income, and allocate capital normally reserved for fixed income to other, risk

ier, assets that can compensate them for their investment. In a vacuum, we wouldn’t blame investors for coming to this conclusion, but basing investment decisions made in a vacuum against a backdrop of an increasingly complicated and integrated global economy and marketplace can lead to ill-timed asset allocation decisions. Take the chart to the below, for example. In a vacuum an investor could say, “Why not put all my money into the S&P 500? Look at the returns I could earn, especially the year-to-date and five-year returns.”

3

While the chart paints an attractive picture of recent historical performance in the S&P 500, it doesn’t tell the entire story. Compare the first chart with the next one that illustrates that equity markets don’t move in a straight line and are prone to drawdowns of varying magnitudes.

4

As this chart illustrates, equity markets can have several years of low- to sharply-negative performance within an overall attractive time period. To look at bonds from only a “total return” perspective ignores the diversification benefits investors achieve by having assets included in a portfolio that generates price movement by different data points and risk sentiments. Specifically, bonds have low correlation5 (please see the above chart) over long time periods, but in times of equity market volatility, bonds typically exhibit negative correlation. This negative correlation is important in investor portfolios because as the equity allocation is experiencing a drawdown, the bond allocation is often able to balance the negative performance by having flat to positive returns (demonstrated in the chart above).

 

Time Period6

Barclays US Aggregate Bond Correlation to S&P 500

Barclays Municipal Bond Correlation to S&P 500

20 Years (1/31/18)

-0.09

-0.05

2011

-0.35

-0.36

2008

+0.35

+0.47

2002

-0.72

-0.84

2001

-0.40

-0.39

It’s often easy to eschew fixed income in favor of equities. It’s even easier to do so when equity markets continually appreciate, seemingly year over year, and as the experience of the great financial crisis fades deeper into the recesses of our memories. But failing to account for the historical volatility and variability of equity returns in lieu of recent favorable conditions in asset allocations would be a disservice to our clients. We do not believe it is possible to forecast when the next large drawdown in the global equity markets will occur, though we do know that another drawdown will happen at some point in the future. When that drawdown does occur, we expect the ballast of our portfolio, our core fixed income allocation, to steady the ship until it returns to calmer waters. Despite a challenging investment environment that lies in its face, core fixed income will remain a critical part of client portfolios.

[1] Asset Allocation in a Low Yield Environment. John Huss, Thomas Maloney, Zachary Mess, Michael Mendelson, August 2017.

[2] The 10 Year US Treasury Bond is assumed to be the “Risk Free Rate” in this illustration

[3] Returns from Morningstar Direct; annualized total returns as of 1/31/2018.

[4] Return source Morningstar Direct. Returns represented are total returns and are one year time period.

[5] correlation defined as degree to which two securities move in relation to one another

[6]Correlations sources Morningstar Direct

Investors should be aware that there are risks inherent in all investments, such as fluctuations in investment principal and with any investment vehicle, past performance is not a guarantee of future results. Indexes shown are unmanaged and investors cannot invest into them directly. The information discussed is meant for general illustration and/or informational purposes only and it is not to be construed as investment, tax or legal advice.  Individual situations can vary, and the information should be relied upon when coordinated with individual professional advice.

 

 

 


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