The COVID-19 pandemic has distorted human interactions, corporate culture, and overall societal norms. It has also upended fixed income portfolios with generation-defining ramifications.
The policy responses and the general risk-off behavior in a heightened macro risk regime have pushed interest rates to historic lows. Yes, after the Global Financial Crisis (GFC), central bank rates went to zero — or near zero. But, for the decade after the GFC, US 10- and 30-year rates averaged around 2.3% and 3.2%, respectively.1 Today, they are trading around 0.90% and 1.65%, respectively, with the yield on the broader Bloomberg Barclays US Aggregate Bond Index (Agg) hovering around 1.23%.2
The challenge in structuring today’s fixed income portfolios is how to diversify the sources of risk in and outside of the core in order to pursue income needs and ensure portfolio diversification.
The lower the yield, the higher the probability of lower future returns
For bonds, there is a strong relationship between the yield at the time of purchase and the subsequent returns. This makes sense, given that the mathematics behind a bond’s yield equate to the expected cash flows from the coupon as well as any price movement related to trading at a premium (negative return expectation as the bond moves closer to maturity at par) or a discount (positive return expectation as the bond moves closer to maturity at par).
Extending the time horizon only magnifies this relationship. For instance, on a three-year subsequent return basis, the straight-line correlation to the yield at the time of purchase for the Agg is 93%, with the five- and 10-year figures at 98%.3 As shown below, the trend between yield and future returns has persisted over time. As yields move lower, so do the subsequent future returns. However, when viewing the correlation between yield and rolling returns on a similar rolling basis, there can be brief periods of decoupling — even if the long-term average is over 90%.
The sizable reduction in interest rates today has led to notable duration-induced price appreciation — core Agg bonds are up 7% so far in 20204 — with this historical relationship decoupling. Yet, this price appreciation will likely dampen potential future returns as the correlation may mean revert — as it has done historically after prior rolling correlation decouplings during other severe risk events (dot-com bust and GFC). In fact, the relationship has already started to mean revert.