This article was updated on March 14, 2017.
Markets entered a new phase in late 2014 as the Federal Reserve took its first step toward normalizing policy. What separates this most recent environment from the prior period immediately following the financial crisis is the fact that, despite ongoing global central bank easing and accommodation, the macroeconomic backdrop and financial markets seem to be experiencing diminished benefits.
During the present economic phase, as central banks continue to keep interest rates low and are buying local bonds at an unprecedented pace, global economic activity and inflation remain modest. What’s more troubling, diminished returns are being produced in the context of heightened uncertainty and volatility. We call this the post-post-crisis period. Investors should consider several principles to invest in fixed income during this new phase.
With growth and inflation muted and largely accommodative monetary policies worldwide, we expect interest rates to remain low. Several developed economies have pushed policy rates into negative territory and have implemented negative deposit rates in an attempt to encourage banks to lend. Even in the United States, where the economy is relatively healthy, the Federal Reserve seeks to increase rates only gradually and has lowered expectations for the long-term neutral interest rate.
In light of our expectation of continued low interest rates, it makes sense to us that investors move out of cash and into core fixed income strategies. Investors have feared for years that interest rates were going to rise, but it seems the market has come around to our view of lower rates for longer.
If we’re wrong, and interest rates were to rise by 1% across the curve in one swift move, bond math suggests that investors in a core bond fund with a 3.2% yield and a 5.7-year duration, for example, would likely lose around 1.5%. We believe that such a rate rise would likely occur only on the back of unexpectedly strong global growth. Regardless of your view on interest rates, however, in today’s uncertain environment, is as important as it’s ever been to hold core fixed income as part of a balanced portfolio.
Lower for longer does not mean, however, that investors should feel comfortable taking a lot of risk in their bond portfolios. Given the low interest rate environment, some investment managers have felt comfortable investing — with some investing heavily — in lower quality bonds in order to boost fund yields. This strategy works well – until it doesn’t.
Given their higher credit risk, high-yield bonds exhibit a very strong correlation to equities of about +0.7. While it has paid to take equity-like risk in bond portfolios in prior years, this strategy does not hold up well in times of equity market volatility, as we saw during the fourth quarter of 2015 through the first six weeks of 2016.
Investors should beware of this type of behavior and avoid investing in core bond strategies that exhibit scope creep. Not all core bond funds are created equal and those that are managed to enhance yield by taking equity-like risk will probably not protect investors against equity market declines.
If investors expect their bond allocations to provide good diversification to equity losses, then the funds they invest in should contain little high-yield bond exposure. Taking too much equity-like risk in bond portfolios can result in the fixed income component declining alongside one’s equity investments when it should be providing downside protection and capital preservation.
Instead of large allocations to high-yield bond funds, we like using municipal bond funds as a tool to boost portfolio yields. Currently, tax-equivalent yields on muni funds are meaningfully higher than their taxable counterparts. For example, the Bloomberg Barclays Municipal Bond Index tax-equivalent yield to worst is more than 1% higher than the Bloomberg Barclays U.S. Aggregate Index’s yield to worst.
Additionally, these tax-exempt bonds are issued by state and local municipalities which are largely insulated from the global dynamics that have recently caused volatility in the taxable bond markets: Brexit, oil price fluctuations and concerns over China’s future growth trajectory. As a result, municipal bond funds have historically demonstrated low correlation to equities.
In today’s environment, investors should not expect a (tax-equivalent) yield of more than 3% to 4% on their fixed income portfolios. In our view, a yield greater than this requires taking too much equity-like risk. Investors should seek a balance of bond funds, with the largest allocations to core tax-exempt and taxable bond funds and high-yield funds occupying a smaller position.
To learn more about the post-post-crisis era, read The Post-Post-Crisis Era: How Bond Funds Can Help Navigate This Volatile Market or download the full white paper.
Bloomberg® is a trademark of Bloomberg Finance L.P. (collectively with its affiliates, “Bloomberg”). Barclays® is a trademark of Barclays Bank Plc (collectively with its affiliates, “Barclays”), used under license. Neither Bloomberg nor Barclays approves or endorses this material, guarantees the accuracy or completeness of any information herein and, to the maximum extent allowed by law, neither shall have any liability or responsibility for injury or damages arising in connection therewith.