Global Head of Fixed Income Investment Strategists
Interest rates have been stubbornly low for years — a trend we think likely to continue. Although bond yields have risen compared with their lows of the past year, along with many investors, we’re skeptical of the case for meaningfully higher rates. As a result, investors are justifiably considering alternatives to fixed income that may offer more return potential.
But focusing on return alone can lead investors to overlook the critical role that fixed income can play in diversifying portfolio exposures. Developed-market sovereign bonds, particularly US Treasuries, have significant risk diversification benefits that can help to offset pain in risk assets. Furthermore, particularly for investors who have sought returns through exposure to illiquid private assets, the relative liquidity of public fixed income can help to efficiently implement portfolio asset-allocation shifts when market volatility strikes.
We also think it’s important not to overlook the potential for certain areas of the fixed income market, including emerging market debt, to provide meaningful returns and yield enhancement. Chinese bonds, for example, enjoy a yield advantage over the bonds of their developed market (DM) peers. The low correlations of Chinese bonds compared with DM bonds also suggests substantial diversification potential in a fixed income portfolio.
The longstanding presumption, borne out by fact, is that in periods of stress in risk markets, investors will seek the safe haven of DM sovereign bonds. Indeed, US Treasuries and the mighty US dollar represent the highest standard for risk-free assets. The resulting demand for US Treasuries drives yields down and prices up, which then diversifies falling asset values elsewhere in a portfolio.
As global yields approached and then fell through zero — a threshold that had previously been considered a floor — many questioned whether the diversification property of DM sovereign bonds would persist.
The data shows that DM sovereign bonds have indeed continued to be diversifying in this context. When we look at the negative interest rate era across developed markets, we notice something interesting: during the most significant fixed income market dislocation during this period (which took place in Q1 2020), US Treasury yields fell significantly more than those in lower-yielding European peer markets. US Treasuries were, in other words, more diversifying than other, lower-yielding sovereign bonds. Certainly the safest-haven status of US Treasuries was a benefit during this period; this phenomenon also took shape because the starting level for US Treasuries was elevated compared with other DM bonds. Figure 1 compares US Treasury bonds’ performance during this period, compared with German bunds and UK gilts.
Figure 1: Lower-Yielding Sovereign Bonds Have Offered Less Diversification Benefit Than US Treasuries
10-Year Sovereign Yield Changes When Equities Decline Less Than 5%
When yields are low and both the income- and total return-generating potential of fixed income are subdued, we believe every dollar invested in fixed income should be maximized. This leads to the case for extending the duration of US Treasury holdings in a portfolio in order to deliver maximum diversification benefit; doing so opens the door to consider a more capital efficient use of funds allocated to fixed income. In the most significant equity market sell-offs in recent memory (in 2008, 2011, and 2020), the corresponding rallies in long US Treasuries approached and even exceeded equities-market declines (see Figure 2).
Figure 2: Rallies in Long US Treasuries Offset Most Significant Equity Sell-offs
The asset allocation of the typical portfolio has evolved far beyond the 60% equities/40% fixed income standard of yesterday. Incorporating alternatives in a portfolio can bring many risk and return benefits but can also introduce liquidity constraints. The illiquidity of many alternative investments creates challenges for investors seeking to efficiently implement asset allocation shifts and to meet ongoing cash flow needs. Liquidity is usually a term connected to cash and Treasuries, but in the context of this investment landscape, we think liquidity should be considered in relative terms.
Take, for example, private credit and high yield fixed income. The draw of private credit for many investors stems from elevated income driven through a leveraged portfolio structure invested in private lending activities. The private nature of the investments means that assets are only periodically assigned valuations. Because these assets are not freely traded, the effect is a smooth return profile compared to investments that are regularly marked to market; however, private credit suffers from very challenged liquidity.
On the other hand, high yield offers elevated income driven through investment in leveraged companies. While there are certainly periods when accessing liquidity in high yield can be difficult, high yield is marked to market daily and in general high yield is much more liquid than private credit. These complementary properties suggest that using high-yield fixed income in combination with private-asset investments can provide investors with the best of both worlds: access to a diversified spectrum of high-income investments, capture of a liquidity premium, and the flexibility to trim or add exposure opportunistically.
This is supported by the long-term return outcomes realized in both high yield and private credit. While observed returns in private credit have been higher than those in high yield, deleveraging the returns on private credit and subjecting the returns to market volatility (akin to high yield) reveals that high yield is a quite strong proxy (see Figure 3). In this manner, the relative liquidity of high yield can improve portfolio risk characteristics of a “modern” portfolio that includes an allocation to private credit.
Figure 3: High-Yield Fixed Income and Private Credit Together Can Increase Portfolio Flexibility
Relative Performance of Public and Private Credit (Cumulative Return %)
Key Takeaways for Investors
Faced with the prospect of persistently low interest rates, alternatives to fixed income that may offer more return potential are understandably appealing.
Globally stimulative fiscal and monetary policies will provide support for spread sectors and the income they provide: corporate and structured credit, investment grade and high yield credit, and emerging markets debt.
We think investors may benefit from using allocations to DM sovereign bonds, especially long-maturity US Treasuries, to diversify risk exposures away from fixed income.
We believe liquidity should be thought of on a relative basis: For example, investors who have sought returns through exposure to illiquid private assets may particularly benefit from the relative liquidity of public fixed income, which can help to efficiently implement portfolio asset-allocation shifts when market volatility strikes.
An allocation to Chinese bonds can introduce both income and diversification benefits to a fixed income portfolio. Inclusion in major indices has broadened the investor base for Chinese bonds and created favorable demand technicals.
The information provided does not constitute investment advice as such term is defined under the Markets in Financial Instruments Directive (2014/65/EU) or applicable Swiss regulation and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell any investment. It does not take into account any investor’s or potential investor’s particular investment objectives, strategies, tax status, risk appetite or investment horizon. If you require investment advice you should consult your tax and financial or other professional advisor. All material has been obtained from sources believed to be reliable. There is no representation or warranty as to the accuracy of the information and State Street shall have no liability for decisions based on such information.
The views expressed in this material are the views of State Street Global Advisors through December 6, 2021 and are subject to change based on market and other conditions. This document contains certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected.
The trademarks and service marks referenced herein are the property of their respective owners. Third party data providers make no warranties or representations of any kind relating to the accuracy, completeness or timeliness of the data and have no liability for damages of any kind relating to the use of such data.
Investing involves risk including the risk of loss of principal.
The whole or any part of this work may not be reproduced, copied or transmitted or any of its contents disclosed to third parties without SSGA’s express written consent.
All the index performance results referred to are provided exclusively for comparison purposes only. It should not be assumed that they represent the performance of any particular investment.
Equity securities may fluctuate in value in response to the activities of individual companies and general market and economic conditions.
Bonds generally present less short-term risk and volatility than stocks, but contain interest rate risk (as interest rates raise, bond prices usually fall); issuer default risk; issuer credit risk; liquidity risk; and inflation risk. These effects are usually pronounced for longer-term securities. Any fixed income security sold or redeemed prior to maturity may be subject to a substantial gain or loss.
Investing in high yield fixed income securities, otherwise known as “junk bonds”, is considered speculative and involves greater risk of loss of principal and interest than investing in investment grade fixed income securities. These lower-quality debt securities involve greater risk of default or price changes due to potential changes in the credit quality of the issuer.
There are risks associated with investing in Real Assets and the Real Assets sector, including real estate, precious metals and natural resources. Investments can be significantly affected by events relating to these industries.
Israel: No action has been taken or will be taken in Israel that would permit a public offering of the Securities or distribution of this sales brochure to the public in Israel. This sales brochure has not been approved by the Israel Securities Authority (the ‘ISA’).
Accordingly, the Securities shall only be sold in Israel to an investor of the type listed in the First Schedule to the Israeli Securities Law, 1978, which has confirmed in writing that it falls within one of the categories listed therein (accompanied by external confirmation where this is required under ISA guidelines), that it is aware of the implications of being considered such an investor and consents thereto, and further that the Securities are being purchased for its own account and not for the purpose of re-sale or distribution.
This sales brochure may not be reproduced or used for any other purpose, nor be furnished to any other person other than those to whom copies have been sent.
Nothing in this sales brochure should be considered investment advice or investment marketing as defined in the Regulation of Investment Advice, Investment Marketing and Portfolio Management Law, 1995 (“the Investment Advice Law”). Investors are encouraged to seek competent investment advice from a locally licensed investment advisor prior to making any investment. State Street is not licensed under the Investment Advice Law, nor does it carry the insurance as required of a licensee thereunder.
This sales brochure does not constitute an offer to sell or solicitation of an offer to buy any securities other than the Securities offered hereby, nor does it constitute an offer to sell to or solicitation of an offer to buy from any person or persons in any state or other jurisdiction in which such offer or solicitation would be unlawful, or in which the person making such offer or solicitation is not qualified to do so, or to a person or persons to whom it is unlawful to make such offer or solicitation.
Investing in foreign domiciled securities may involve risk of capital loss from unfavorable fluctuation in currency values, withholding taxes, from differences in generally accepted accounting principles or from economic or political instability in other nations. Investments in emerging or developing markets may be more volatile and less liquid than investing in developed markets and may involve exposure to economic structures that are generally less diverse and mature and to political systems which have less stability than those of more developed countries.
Issued by State Street Global Advisors, Australia Services Limited (AFSL Number 274900, ABN 16 108 671 441) ("SSGA, ASL" or "State Street Global Advisors, ASL"). Registered office: Level 14, 420 George Street, Sydney, NSW 2000, Australia · Telephone: 612 9240-7600 · Web: www.ssga.com.
State Street Global Advisors, ASL is the issuer of interests and the Responsible Entity for the ETFs which are Australian registered managed investment schemes quoted on the AQUA market of the ASX or listed on the ASX. This material is general information only and does not take into account your individual objectives, financial situation or needs and you should consider whether it is appropriate for you. You should seek professional advice and consider the product disclosure document and target market determination, available at www.ssga.com/au, before deciding whether to acquire or continue to hold units in an ETF. This material should not be considered a solicitation to buy or sell a security. ETFs trade like stocks, are subject to investment risk, fluctuate in market value and may trade at prices above or below the ETF's net asset value. ETFs typically invest by sampling an index, holding a range of securities that, in the aggregate, approximates the full index in terms of key risk factors and other characteristics. This may cause the fund to experience tracking errors relative to performance of the index. Investing involves risk including the risk of loss of principal. Diversification does not ensure a profit or guarantee against loss. Holdings and sectors shown are as of the date indicated and are subject to change. This information should not be considered a recommendation to invest in a particular sector or to buy or sell any security shown. It is not known whether the sectors or securities shown will be profitable in the future. Sector ETF products are also subject to sector risk and non-diversification risk, which generally results in greater price fluctuations than the overall market. SPDR®, Standard & Poor’s® and S&P® are registered trademarks of Standard & Poor’s Financial Services LLC, Dow Jones® is a registered trademark of Dow Jones Trademark Holdings LLC, ASX® is a registered trademark of the ASX Operations Pty Ltd, these trademarks have been licensed for use by S&P Dow Jones Indices LLC and sub-licensed for use to State Street Global Advisors, ASL. MSCI indexes are the exclusive property of MSCI Inc. (“MSCI”). MSCI and the MSCI index names are service mark(s) of MSCI or its affiliates and have been licensed for use for certain purposes by State Street. SPDR products are not sponsored, endorsed, sold or promoted by any of these entities and none of these entities bear any liability with respect to the ETFs or make any representation, warranty or condition regarding the advisability of buying, selling or holding units in the ETFs issued by State Street Global Advisors, ASL. State Street Global Advisors Trust Company (ARBN 619 273 817) is the trustee of, and the issuer of interests in, the SPDR® S&P 500® ETF Trust, an ETF registered with the United States Securities and Exchange Commission under the Investment Company Act of 1940 and principally listed and traded on NYSE Arca, Inc. under the symbol "SPY". State Street Global Advisors, ASL is the AQUA Product Issuer for the CHESS Depositary Interests (or "CDIs") which have been created over units in SPY and are quoted on the AQUA market of the ASX. The whole or any part of this work may not be reproduced, copied or transmitted or any of its contents disclosed to third parties without State Street Global Advisors, ASL's express written consent.