As you age, one of the most common bits of advice you’ll hear is to stay active. This is almost always referring to the importance of exercise and its role in maintaining your health, but the same can be said when thinking about fixed income as part of your asset allocation.
Fixed income performs an important role in helping investors to preserve capital and generate income, thanks to regular coupon payments acting as a stable source of income year after year. As individual investors age, the common investing wisdom has been to move towards an ever larger allocation in fixed income. But in the current low interest rate environment, investors have been questioning this approach. After all, what good is investing in fixed income if you aren’t getting much yield?
But taking such a narrow view ignores the bigger picture and could lead to missing out on other benefits an allocation to fixed income can provide. The main role of fixed income has always been to preserve and protect capital; providing stable income is secondary. Additionally, low rates haven’t eroded the purchasing power of savers that invest in the asset class, as inflation has been well-contained over the last eight years.
Additionally, although assets that are perceived to be risky (such as US equities) have enjoyed a fairly decent run in recent years, if we look at a longer time periods, such as from the start of the century, their returns still trail cumulative bond returns, as shown in the chart below. And those return profiles were achieved with significantly lower volatility compared to those of riskier assets.
Asset class volatility (annualised standard deviation of monthly returns) vs. annualised returns, 2000-2017
Source: Morningstar, April 30, 2017. Past performance is not indicative of future results. US Treasuries are backed by the full faith and credit of the US government.
When rates rise
In a rising rate environment, fixed income continues to be an important part of the overall portfolio, but there are different risks to consider. As the US Federal Reserve (Fed) embarks on a course to gradually normalise interest rates in the US, we may see Treasury rates move higher by 100 to 200 basis points in the next few years.1As a result, risk premiums in spread products (such as investment-grade credit and high yield bonds) are expected to increase, as many are currently near historical lows. Since bond prices move inversely to yields, many retail investors may suddenly discover that their fixed income funds can lose value.
Therefore, there are certain attributes that become more important for a fixed income strategy so that it can help a portfolio guard against such risks. First, a strategy should have the ability to move duration to near zero. This lowers the portfolio’s sensitivity to movements in interest rates. Another tool bond investors should have at their disposal is the ability to invest in bond markets outside their home countries. This is because foreign markets can be at different points in their economic or monetary cycles, where the central bank is either on hold or cutting rates. For example, Indonesian government bonds experienced capital appreciation as US interest rates rose over the last 12 months. Finally, a fixed income strategy should be able to shift its risk profile actively and avoid blindly chasing yield when yield levels and spreads are compressed. For example, maintaining a large exposure to low quality corporate bonds is not prudent, in our view, given elevated valuations and despite supportive fundamentals in the intermediate term.
In a shrinking active management industry, only the fittest will survive.
An actively managed approach to managing fixed income possesses all of these qualities. However, active managers are facing an increasingly competitive environment, as the threat from passive investing forces them to prove their worth. In a shrinking active management industry, only the fittest will survive. Investors will need to pay close attention to a manager’s process and long-term record.
Many investors are questioning why they should even bother with actively managed bond funds. We believe there are at least two good reasons. First, unlike stock indexes, which somewhat track the growth of the economy or technology, bond indices lead investors unreasonably into assets that have deteriorating fundamentals. The more debt an entity issues, the more its share in index expands and, as a result, passive investors end up owning bigger portion of bonds issued by a company with a worse leverage profile.
The low interest rate environment in the past decade has encouraged corporations and governments to increase borrowing and extend their debt maturities. For example, US corporations issued 30% more long duration bonds in 2016 compared to the previous year. The US Treasury has also been issuing plenty of 30 year bonds and has recently floated the idea of launching a 50 year bond to finance potential fiscal stimulus in 2017.
This has naturally extended the duration profile of bond indices. The most commonly used broader-market bond index, Bloomberg-Barclays Aggregate Bond Index, now has a duration (or interest-rate sensitivity) of 6 years compared to 4.5 in 2007. This implies passive investors are 30% more exposed to rising rates today than they were 10 years ago.
Secondly, quantitative easing and poor funding of public long-term liabilities has created significant distortion in bond markets due to the dominant influence of “uneconomic” investors, such as central banks, that buy bonds without considering the total return. As central banks start normalising monetary policies without a historical precedent to reference, unusually low rates and risk premiums create a demand for more fundamental research and risk management. Under the circumstances, managers who can confidently invest in large portions of assets outside of index and with broadest opportunity set to choose from are best placed to deliver risk-adjusted returns.
One simple fact that bond investors should keep in mind is that, over the long run, their portfolios’ return will be predominantly derived from income. And fixed income will be one of the main contributors to this effort, provided that the strategy is nimble enough to adapt to changing market environments. With this approach, staying active is essential.
Image credit: Ernst Photography / Alamy Stock Photo
1Forecasts and estimates are offered as opinion and are not reflective of potential performance, are not guaranteed and actual events or results may differ materially.