August 2020 was a month for the record books, just a few months removed from quite possibly the deepest but shortest recession in modern times. With U.S. 10-year Treasury yields setting record lows, and U.S equities (S&P 500) hitting record highs, some investors are questioning whether traditional core fixed income can still serve as effectively as a ballast in portfolios.
The interest rate sensitivity of core bonds has historically served as a diversifier to equities, providing price appreciation potential and resiliency in the face of stock market declines. Core bonds generally have been used to help dampen overall portfolio volatility while pursuing attractive returns that can outpace inflation.
Let’s look at how the traditional appeal of core bonds stacks up today.
Re-examining the value proposition of traditional fixed income
Dampening volatility: In isolation, core bonds display higher volatility than cash. However, in a portfolio that includes equity and other riskier holdings, core bonds have historically offered a reduction in volatility similar to that achieved by holding cash, but with higher returns (see chart). This volatility-dampening benefit is a function of the generally negative correlation that core bonds can display to equities. Even with interest rates somewhat range-bound at lower levels, we believe this correlation benefit should persist – that is, rates could still go lower in a negative growth scenario when equities and risk assets underperform.
Diversifying risk assets in periods of market stress: Core bonds also have had the ability to provide positive return potential when riskier assets face drawdowns. This is because interest rates tend to fall (benefiting rate-sensitive assets) when credit or equity performance is challenged (e.g., by the end of Q1, the Bloomberg Barclays U.S. Aggregate Index (“U.S. Aggregate Index”) was up 3.15% when the S&P 500 was down 19.60%). With interest rates at today’s low levels, the room to decline is potentially more limited than before – but rates can still fall even in what will likely remain a fairly range-bound rate environment. Moreover, to the extent a more negative growth scenario were to take hold, we would expect rates to decline substantially and thus deliver price appreciation potential (a severe negative shock could push yields to zero, and with 10-year Treasuries yielding about 0.7% lately, a decline to 0% yield would imply price appreciation of over 4%i).
Supplementing returns: Although the level of yields may have declined, we believe the potential for active management to generate alpha has remained fairly consistent. In fact, with yields on the U.S. Aggregate Index just above 1%, active management may become more critical as alpha could likely be a larger share of returns going forward. With the average active core plus manager capturing a 0.7% yield advantageii over the U.S. Aggregate Index, the return potential is not that dissimilar to years past at inflation plus 1% to 2%. The opportunity for solid returns from active core management – and the potential for price appreciation and resiliency during volatility – can be compelling in a world of low return expectations across asset classes.
Adapting portfolios to the world ahead
Fearing lower returns from core bonds, some investors may be tempted to reduce such holdings in favor of cash or equities. However, if one were to use the example of insurance, it becomes clear that the response to a decline in the potential payout should not be to either own less insurance (i.e., go to cash) or take more risk (buy more equities).iii
Instead, investors may find it prudent to examine their asset allocation through the same lens that we apply within core portfolios. With duration offering somewhat diminished diversification to credit and other spread risk, reducing concentrations and broadening the types of spread risk is critical in our view – i.e., emphasizing less correlated assets to embed resiliency.
In addition to maintaining duration, we find value in U.S. agency mortgage-backed securities, where overall yields are compelling, especially for an asset class with a government or Agency guarantee, direct and substantial Federal Reserve support (via current asset purchases),iv and robust liquidity (compared to corporate credit). We are emphasizing higher-quality investment grade credit and focusing on sector- and credit-selection over generic beta exposure given the dispersion between and within sectors (for markets but also the broader economy) and in recognition of an evolving credit cycle that could lead to more downgrades and defaults. Other securitized credit, particularly higher up the capital structure, can also provide compelling risk-reward profiles and the potential for resiliency in what is likely to be a long and uneven economic recovery.
So yes, rates are low, but we believe the defining features of core bonds – diversification and return potential – continue to make them a critical component of a well-balanced portfolio.