Investors have enjoyed a generation-long secular bull market in bonds—with yields steadily declining from the highs of the early 1980s until today. Unlike stocks, bond returns are derived almost exclusively from income over long periods of time. But with current income levels below 2% on the benchmark 10-year U.S. Treasury, future bond returns are significantly constrained.
Thus, you face a dilemma as you assess the merits of this current low-return asset class:
- Are the income generation and stability enhancement roles that bonds play in your portfolio still valid?
- Or is there another asset class that can substitute for the combination of income generation and volatility dampening?
Due in part to the ongoing pandemic as well as various central bank policies, interest rates are historically low. Nevertheless, now’s the time to begin thinking about how rising rates in the future may begin to impact your portfolio.
Providing income and protecting principal—still the case?
Bond math is comfortingly inexorable. When yields go up, bond prices go down—and the longer the bond maturity, the more the price will vary for a given change in yields for bonds of similar coupons.1 The risk of large losses due to a change in the interest rate environment for traditional intermediate maturity holdings is greatly reduced by the support of the coupon payment. Very long maturity bonds with low coupons will have more price volatility, but these aren’t commonplace for most investors.
As the chart below depicts, while bond returns can be negative for a one year period of time, historically there have been no instances of multi-year negative returns (and in fact, any periods of negative return have been recouped within the next years’ experience). This strongly supports the use of bonds as a stability source within your portfolio, albeit with very low return expectations at today’s low yields.
Individual bonds can be held to maturity; at which point they will pay 100 cents on the dollar. There may be an opportunity cost if rates rise after the purchase of an individual bond. But when held to maturity (and if purchased at or below par) there should be no realized loss. Since individual bonds can be difficult to purchase due to the frictional drag of transaction and diversification costs, bond mutual funds and ETFs have become the default mechanism for providing fixed income returns. While not having a specific maturity date, bond funds can contain a variety of maturities, durations, and credit exposures. Careful selection of fund can provide many of the same risk buffers as high quality individual bonds for your overall portfolio management needs.
What Lies Ahead?
The question that’s on everyone’s mind is what exactly the future path of interest rates will look like. The chart above offers a 40-year perspective on the gradual decline of rates since the mid 1980’s, from levels of 9% + to 2021 yields of around 1.2%. The decline in interest rates has arguably been the most important factor driving U.S. financial market returns on a secular basis for a generation. Given current rock-bottom yields, however, there’s really only one direction in which they can now move.
In a normally expanding economy, rising short-term rates (which are somewhat within the control of the Fed) frequently precede rising longer-term rates (which are set by market forces of supply and demand as investors buy and sell bonds in and out of investment or trading portfolios). The distribution of rates from short maturities of 3-6 months to longer dated maturities of 20-30 years comprise the ‘yield curve.’ One of the unique aspect of the present market cycle has been the activity of the Federal Reserve since 2010—when policymakers decided to pursue a strategy known as ‘Quantitative Easing’ in an effort to lift a lackluster GDP trajectory onto a higher path.
‘QE’ became the term used to describe the Federal Reserve purchasing bonds in the marketplace (in the U.S., purchases were limited to Treasuries and Agency mortgage securities) in an effort to affect not only the short end of the yield curve through the traditional mechanism of setting short-term rates, but also the longer end of the yield curve by altering the supply and demand dynamics in a manner that supported higher bond prices (meaning lower bond yields) than would otherwise be the case. With interest rates thus suppressed along the entire yield curve, the cost of financing new economic activity was reduced and higher levels of investment and activity should have resulted.
The outcome was mixed, with overall GDP and employment growth remaining stubbornly modest even in the face of historically low interest rates. Excess capacity in the economy and workforce was gradually reduced and the economy reached a point where the Fed began removing some of the unique supports that had been in place. Then along came COVID-19. Not only were the breaks put on, but the supports were reinstituted.
We do not know how the economy will respond to future rate increases and whether the somewhat stronger levels of economic activity we are beginning to see re-emerge, will endure in a higher rate environment. The new administration may bring with it a renewed interest in fiscal spending, which may be financed by additional government borrowing and could lead to higher interest rates and inflation measures, if such programs can be agreed upon and implemented. Neither the agreement nor the implementation is certain.
The breadth of the potential outcomes for the intermediate future is surprising wide, and with such a wide range of future scenarios we’re acutely aware of the benefits of diversification. Portfolios should include assets that can preserve value in difficult environments as well as assets that can provide growth and income in more hospitable times. Transparency and liquidity should be the hallmark of most positions, while some investors may be able to accept illiquidity in exchange for premium returns.
There are several forms of diversification available to the long-term investor: both between asset classes (i.e., a mix of stocks, bonds, cash, and alternatives) and within asset classes (i.e., equity style categories, differing bond categories, etc.). Both are important. But for the balance of the current discussion we’ll focus on diversification within the fixed income portfolio itself as well as some proposed bond substitutes.
We should first outline the factors that determine bond prices across different types of bond investments. The impact of interest rates is well known—the overall level of interest rates is the primary driver of most investment grade bond prices. The coupon structure is also a driver, with low-coupon bonds generally experiencing larger price swings for a given change in interest rates than higher coupon offerings. Generally, the lower the coupon rate, the higher the duration for bonds of similar maturity.
Credit risk is typically the next most influential determinant of pricing—with corporate bonds trading at interest rate spreads to similar duration U.S. treasuries based on the market’s perception of their creditworthiness. For corporate bond investors, the additional spread in interest rates can sometimes overcome price changes triggered by shifts in the overall interest rate environment (if the cushion is sufficiently plump). Alongside credit concerns, for non-U.S. bonds denominated in local currencies, exchange rate concerns can be a factor, with non-dollar denominated bonds reflecting the market’s opinion of the likely path of relative currency values over the course of the bond interest and principal payment lifespan in addition to credit considerations.
The liquidity profile of bond investments can also vary significantly by type, with U.S. Treasury bonds typically offering superior liquidity to other offerings, especially in periods of market turmoil. Liquidity, or the ability to trade a position without experiencing substantial frictional transaction costs, only becomes important when an investor needs to buy or sell a position—at which time it becomes of paramount importance.
Non-investment grade (high yield) bonds have also earned a place in many institutional portfolios owing to their generous yield premiums and relatively acceptable risk profiles. Many investors view high yield bonds as an asset class that combines some of the risk profile of a fixed income instrument with some of the return profile of an equity investment (as prices frequently correlate with the stock price of the underlying company). However, high yield bond spreads can be very sensitive to market dynamics, and trading liquidity can rapidly become problematic during periods of overall market stress or in the face of company-specific concerns. Diversification between credits and a careful selection process of credit exposures is especially important for the high yield portion of any fixed income portfolio.
There’s no question that fixed income portfolio diversification offers a number of tools to mitigate an increasing interest rate environment via the selection of different classes of bond investments. But any diversification away from traditional government bonds and high quality corporate bonds brings with it additional risk factors to your portfolio.
Are there bond alternatives that can provide income and stability?
As interest rates steadily declined, investors have searched for other solutions to replace the risk mitigation and income streams that bonds have traditionally provided. Some interesting and useful investments have emerged that can help fill this role in a diversified portfolio—but there’s no perfect solution.
Following the 2008-2009 financial crisis some investors turned to alternatives, where hedge funds can apply a number of Absolute Return strategies that strive to produce low volatility and consistently positive return patterns. The experience has been mixed—as the high imbedded fees from alternatives combined with increasingly competitive financial markets have resulted in returns that are broadly disappointing. In late 2016, as interest rates rose, alternatives did provide some downside buffer during a period when bond market returns were briefly negative, so it remains to be seen if allocating to alternatives will meet the strategy’s intended goals. For most investors however, alternatives aren’t an appealing bond replacement.
Not only are many alternative strategies available only to large institutional investors (due to regulatory requirements), but for the most part they’re highly illiquid and don’t provide easy access to ready cash that a traditional fixed income holding can provide—especially in the midst of turbulent markets. While often useful as portfolio stabilizers, they don’t provide the levels of income that a bond portfolio has traditionally delivered. Therefore, an allocation to alternatives can substitute for a portion of the ‘risk mitigation’ segment of a balanced portfolio, as long as the differences in the return profile, income structure, and liquidity structure are fully incorporated in overall portfolio planning.
High yielding stocks and high yield bonds can take on some of the income generation responsibilities in a diversified portfolio previously borne by the bond allocation. This strategy has the added appeal that high quality high yield equities may offer dividend growth over time (in addition to current income). Investors have pursued traditional high yielding equities such as utilities and REITs (Real Estate Investment Trusts) in an effort to boost portfolio cash flow. Such strategies are reasonable within the context of a diversified portfolio, with the caveat that as investors pursue higher yielding stocks, the price of those stocks can rise above the level of their long-term fair value and create price risk when investor interest in the yield strategies diminish and interest rates begin to rise.
While some investors have allocated away from bonds to increase income levels, to the extent they do so, they lose the price stability of bonds and expose their portfolios to higher levels of overall volatility. Some high dividend yield equity funds will concentrate their investments in certain economic sectors that are generally marked by high dividend yielding stocks—which can lead to a deterioration in diversification benefits. High yielding equity allocations should be thoughtfully analyzed to avoid undue concentrations, which can result in performance volatility during difficult market environments.
The bottom line is that there’s no ideal substitute for fixed income positions. Investors are faced with the dilemma of accepting very low returns in exchange for a highly certain return of principal. While frustrating, our view is that most investors should still consider holding a portion of their portfolio in fixed income given the asset class’s stability, liquidity, and transparency. Although actions can be taken around the margin to boost return, one role of the bond allocation should remain that of portfolio stabilizer—to hedge against periods of future market uncertainty. The chart below clearly shows, on average, that a diversified portfolio holds up better than a pure bond portfolio during periods of increasing rates (again, as defined by increases in the 10-year U.S. Treasury yield). There is, however, marked variability between time periods and asset classes, which offers an important reminder of the importance of overall portfolio diversification and the impact of an ‘all-weather’ portfolio.
As long-term pools of capital continue to move from an income-only strategy towards a total return approach, our recommendation is that it’s an opportune time for your organization to position allocations in advance of a rising rate environment. If the focus is purely income, then consider diversifying within fixed income. If total return is your primary driver, investment committees might look to improve risk-adjusted returns by investing in other asset classes prescribed by your investment policy (with the understanding that such allocations aren’t perfect substitutes). As with many things, moderation and balance are the keys to long-term investment success in an environment marked by shifting currents and evolving expectations.
Making your fixed income allocations work
Nonprofit organizations with a third or more of your investments in core bonds need to be thoughtful about the purpose that fixed income is expected to serve. At least annually, your investment committee should affirm that the risk profile described within your Investment Policy Statement makes sense for the organization. We believe there are ways to mitigate downside risk and still generate meaningful portfolio returns—by diversifying within fixed income, or reallocating in part from fixed income into other investment categories. Now is an opportune time to add fixed income allocations to the agenda for your next committee and/or board investment discussion.