Fixed Income Dilemma

What are we to do about fixed income?  Current yields are low at all maturities, for all except the riskiest issues.  In addition, investors currently holding bonds or bond funds are looking at interest rates that can seemingly only rise, leading to losses in value.

Let’s start by examining why we hold bonds in the first place, and how they have been performing relative to those reasons.  Bond ETFs will be used as a proxy for bond performance.  Investment grade bonds are represented by AGG, which tracks the Barclays US Aggregate Bond Index (data at morningstar.com and https://www.ishares.com/us/products/239458/ishares-core-total-us-bond-market-etf).  High yield bonds are represented by HYG, which tracks the Markit iBoxx USD High Yield Index (data at morningstar.com and https://www.ishares.com/us/products/239565/ishares-iboxx-high-yield-corporate-bond-etf).

  1. Low risk.  A core justification for owning investment grade bonds is that they rarely lose value, and when they do, it’s not much.  3 year standard deviation is 2.64%, compared to 6.01% for HYG, and 10.8% for SPY.
  2. Diversification.  The equity beta for AGG vs. the S&P500 is -.03 as of 9/30/2016.  This tells us that AGG is a very good diversifier to stocks.  From a portfolio construction standpoint, this is not to be taken lightly.  On the other hand, HYG has a beta of .40.  Still a diversifier, but as one would expect, more positively correlated with equities.
  3. Income.  Those who are retired, and many advisors, see bonds or fixed income assets as a way to earn money from savings without touching the money that was saved (spend earnings instead of principal).  Since money is fungible, this is really just a behavioral bias (mental accounting).  However, since all of our clients are humans who exhibit these biases, if it makes a client feel terrible to sell 2% of assets that have appreciated 2%, but feel good to take the income from an asset that has 0% return but 2% yield, then that might be a valid reason to use bonds for income.  AGG has been yielding about 2% YTD, and HYG about 3.5%(!).
  4. Regulations.  This is not a small consideration.  New fiduciary rules impact portfolio management, and portfolio managers will need to document extensive research to back up deviations from “standard” portfolios, which might by default include substantial allocations to fixed income for certain types of clients.

What about going forward?  Will these assumptions still hold, given global negative interest rates (see Eric Robbins’ article in this issue) and the historic bond bull market in US Treasuries?  I’m going to focus just on the first item on the list.

Low risk.  Is it possible for bond values to remain elevated, with depressed yields, for any mid- to long-term time frame?  The driving force behind this dynamic since the great recession has been QE.  According to the Fed’s website, approximately $45B of their $4T balance sheet will mature in the next quarter.  Also from the Fed, new mortgages are being issued at a rate of about $100B per quarter, and according to SIFMA, new US Treasury issues have totaled an average of $165B per quarter.  So in order for the Fed to maintain their current balance sheet, they alone are currently consuming nearly 20% of all new Treasury and mortgage debt issued in the US.  Foreign governments are also engaged in QE.  According to the US Treasury, their holdings of US debt have remained fairly constant over the last year at around $6T.  These holdings also mature, so there is implied demand for new issues from foreign buyers as well.

Jeff Gundlach feels that, based on presidential election political rhetoric, a new round of fiscal stimulus is forthcoming, which will overwhelm these buyers and result, along with Fed interest rate changes, in increasing rates (September 8 presentation, available from DoubleLine).  He recommends moving to lower duration securities and cash, right now.  I would add the observation that government spending comes from Congress, not the White House, so it is the congressional makeup that will determine fiscal policy action, or lack thereof.  Fidelity does not share Gundlach’s view (update from Fidelity website).  Bill Irving believes that “yields will remain at historically low levels for some time.”

Another consideration is that we are, historically, past due for a recession.  This typically results not only in large losses in equities, but a flight to quality, supporting  bond prices.  The bottom line:  Rates are not likely to remain at current lows forever.  However, federally backed debt, which comprises 70% of AGG (including agency and implicit government-backed debt), may continue to hold value in the short or even mid term.  If you look at a graph of the Federal funds rate, you will notice that while interest rates drop in huge increments, they only increase in small increments, over time.  These interest rate changes have previously been implemented slowly enough for the average investor to adjust asset allocation before major impairment to asset values can occur.

Corporate debt, according to both Irving and Gundlach, is now trading at historically normal spreads.  John Hussman provides a lot of data showing that today’s equity market is highly overvalued.  These data points together suggest that corporate debt may not be adequately compensating for credit risk.  Instead, corporate bonds have been bought beyond reasonable levels in the quest for yield (adding credit risk).  That strategy may be a greater risk to overall portfolio value than interest rate risk.  In fact, if high yield bonds have been added to a portfolio including US equity, the risk is now even larger since there is positive correlation between those asset classes.  Gundlach suggests emerging market debt in place of high yield domestic corporate bonds.  Foreign bonds add currency risk, but that can be hedged (for a price).

Another option is to make use of actively traded long/short bond funds or SMAs.  Although the exposure will always be to bonds, this is not an asset class that acts like a bond, but instead is an alternative.

So, what to do?  Assess the timeline of your portfolio, and compare it to basic bond management theory.  Can you match duration to reduce interest rate risk?  Can you use a barbell strategy to reduce interest rate risk and still meet your return requirements?  If this doesn’t work, what kind of risk are you willing to take?  Are you willing to live with interest rate risk, at least in high quality US issues?  Are you willing to take credit risk as well as adding to your overall portfolio risk by adding high yield, preferred stock, or foreign bonds?  Does it make sense to reduce your bond exposure and invest in another asset class?  As you look at these trade offs, be sure to determine your criteria for further review and action.   Set a specific interest rate cutoff (and/or whatever other data points you deem valuable), and determine what actions you will take when it is reached.  Set a specific review date, and determine what data you will review at that time.  And last, but far from least, be sure to record your process for compliance.

Disclosure:  Long AGG, SPY

 

 

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