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.
With the current yield environment at a near-record low for core bond sectors (1.23%),5 and based on the relationship above, investors could expect a similarly low annualized return from core bonds over the next three to five years (i.e., around 1%). Yet, the low return is not being met by lower risk. The duration of an Agg exposure is six years,6 a problematic profile if rates do eventually rise. A modest rise of 50 basis points to the Agg’s yield would still result in a theoretical 1.27% capital loss, as the yield today is far too low to offset any impact duration has on price.7
Today’s low and asymmetrical income and risk/return profile is an issue for an exposure that often comprises a large part of an investor’s portfolio.
Overweighting mortgage-backed securities in the core
While we expect today’s generationally low rates to remain low for some time, the US Treasury curve may bear-steepen (long-term rates rise faster than short-term rates do) over the coming months, driven by three variables:
The Federal Reserve keeping its policy rates low,8 anchoring short-term rates to the zero bound
The US Treasury continuing to borrow to fund stimulus programs, putting upward pressure on long-term rates
Positive vaccine news spurring longer-term growth expectations, lifting term premiums that have already climbed 36 basis points over the past three months9 even higher.
A higher US 10-year yield may improve income prospects, but it doesn’t overcome the asymmetrical risk/return profile of Treasuries and, therefore, the Treasury-heavy Agg. As a result, investors should consider overweighting mortgage-backed securities (MBS) in the core, as the sector has provided higher income than Treasuries (1.34% versus 0.61%) while offering more balance from a risk perspective (4.5 years less in duration, and lower historical volatility of 2.43% versus 4.87%).10 Additionally, MBS have had a higher yield, lower duration, and less historical volatility (1.34%, 2.5 years, and 2.43%, respectively)11 than the broader Agg itself (1.19%, 6.22 years, and 3.71%, respectively). And MBS’ historical negative correlation to equities (-22%) may allow them to be a potential diversification tool as well.12
MBS also have potential advantages over another core sector — investment-grade corporates. MBS now yield 61 basis points less than investment-grade credit, but with lower duration (2.5 versus 8.77 years), reduced spread risk (54 versus 114 basis points), and less historical volatility (2.43% versus 4.56%).13 Optimizing the broad corporate bond index to obtain a duration similar to MBS’ 2.5 years would equate to a yield on corporates of just 0.77%14 — indicating that MBS offer a higher yield on a duration-adjusted basis. This structurally unique yield per unit of risk exposure may results in a higher yield in the core without adding risk (in fact, volatility is reduced, as discussed above), allowing income-seeking investors to take risk elsewhere.
Adding ancillary bond segments
In this abnormal yield-starved environment, generating income on par with historical figures requires investors to outlay more risk through duration (long-term Treasuries), credit (high-yield bonds) or equity-related exposures (high-yield dividend/preferred stocks), for example. Adding duration is likely unattractive, as extending out to long-term core bonds results in an only 1.5 percentage point increase in yield, but it is accompanied by a 10-year extension of duration.15 With little uplift in yield — but a big increase in rate risk — that risk/return trade-off is vastly asymmetrical.
As a result, adding ancillary bond segments to the core may help to provide both income and diversification. Each of the three segments below carries a yield north of 3.5%, but with a different source of risk.
High yield bonds or senior loans: Both sectors may offer yields close to 5%. However, in this market — where spreads are tight (20% below 20-year average),16 defaults are elevated, and idiosyncratic risk is high — the profile and structure of senior loans represent a more ideal credit allocation. By bringing in duration and sitting higher in the capital structure, senior loans may be able to help navigate today’s credit dynamics better than a traditional high yield allocation would, as senior loans have historically experienced lower default rates (4.3% vs. 5.8%) and higher recovery rates (46.7% vs. 15.3%).17 And with a beta/correlation of only 0.23/0.63 to equities (versus 0.37/0.80 for high yield),18 senior loans may provide similar income, but without adding as much implicit equity risk.
Emerging market local debt: Emerging market local debt (EMD) currently yields 3.56%19 — two full percentage points above traditional core US aggregate bonds. Yet, the uptick in yield is not from additional below-investment-grade risk, as 85% of issuers are rated investment grade.20 And it is not from elevated rate risk, as EMD has a historical 9% correlation to the rate-sensitive Agg.21 Instead, currency trends play a significant role in the risk and return profile of EMD, as the correlation between EM local sovereign debt monthly returns and EM local currency monthly returns is 92%, with the R-squared of the regression at 85% — indicating a strong fit and relationship.22 As a result, the high levels of income are a function of associated currency/political risk. From a total return perspective, the currency risk may be rewarded over the coming months if the US dollar (USD) continues to weaken (USD is down 8% over the past six months),23 given the US’ waning yield advantages over other currencies and a ballooning public deficit that is likely to increase if a second stimulus bill is passed.
Preferred stock: At 4.62%, the yield on preferreds is comparable to that on high yield bonds. However, unlike high yield, preferreds are mainly (80%) investment grade.24 Additionally, with relatively low historical correlations to traditional stocks and bonds — 0.58 and 0.41, respectively — and a beta of 0.30 to stocks,25 preferreds may help diversify portfolio income generation. Overall, preferreds may offer an income stream similar to that of high-yield exposures, but with potentially lower credit risk and equity sensitivity because they typically hold mostly investment-grade-rated securities from the highly regulated banking and insurance sectors.26
As shown below, framing the income conversation as income per unit of volatility illustrates the potential benefit of these non-core bond sectors — as well as exposure to MBS in the core. With elevated ratios, they all may provide income in our low-rate environment without completely forcing a portfolio to pursue income from just one specific “risk bucket.” In addition, these market segments may still offer the necessary diversification when added to the broader portfolio, as correlations to traditional stocks and bonds are constructive.
These funds may help investors seeking to balance risk in the pursuit of income.
In the core, target mortgages to reduce volatility but seek higher income, and consider:
SPDR® Portfolio Mortgage Backed Bond ETF
Outside of the core, consider diversifying credit risk with senior loans; currency risk with emerging market debt; and a hybrid of credit and equity risk with preferreds, and consider:
SPDR® Blackstone / GSO Senior Loan ETF
SPDR® Bloomberg Barclays Emerging Markets Local Bond ETF
SPDR® Wells Fargo® Preferred Stock ETF
1 Bloomberg Finance L.P. as of November 16, 2020., based on rate levels from 12/2009 to 12/2019. 2 Bloomberg Finance L.P. as of November 16, 2020. 3 Bloomberg Finance L.P. as of November 16, 2020, calculations by SPDR Americas Research by calculating the long-term correlation of the yield and return streams for a specific period. 4 Bloomberg Finance L.P. as of November 16, 2020, based on the Bloomberg Barclays US Aggregate Index. 5 Bloomberg Finance L.P. as of November 16, 2020 based on the yield-to-worst for the Bloomberg Barclays US Aggregate Bond Index. 6 Bloomberg Finance L.P. as of November 16, 2020 based on the option adjust duration for the Bloomberg Barclays US Aggregate Bond Index. 7 The return is based on the rates change (50 basis points) multiplied by the duration (6 years), plus the assumed return for a year given the higher rate (1.58%). (-0.50% * 6) + 1.73% =-1.27%. 8 “Fed Signals Interest Rates to Stay Near Zero Through 2023”, Wall St. Journal September 16, 2020. 9 Bloomberg Finance L.P. as of November 16, 2020 based on the Adrian Crump & Moench 10-Year Treasury Term Premium. 10 FactSet, Bloomberg Finance L.P. as of November 16, 2020 based on the index characteristics for the Bloomberg Barclays US Treasury Index, and the Bloomberg Barclays US Securitized Index. Volatility as measured by 36-month volatility of daily returns from 11/13/2017 to 11/13/2020. 11 FactSet, Bloomberg Finance L.P. as of November 16, 2020 based on the index characteristics for the Bloomberg Barclays US Aggregate Bond Index, the Bloomberg Barclays US Treasury Index, and the Bloomberg Barclays US Securitized Index. Volatility as measured by 36-month volatility of daily returns from 11/13/2017 to 11/13/2020. 12 Bloomberg Finance L.P. as of November 16, 2020 based on the correlation of monthly returns between 11/18/2015 to 11/13/2020 between the Bloomberg Barclays US Securitized Index and the S&P 500 Index. 13 FactSet, Bloomberg Finance L.P. as of November 16, 2020 based on the index characteristics for the Bloomberg Barclays US Corporate Index, and the Bloomberg Barclays US Securitized Index. Volatility as measured by 36-month volatility of daily returns from 11/13/2017 to 11/13/2020. 14 Bloomberg Finance L.P. as of November 16, 2020 based on the index characteristics for the Bloomberg Barclays US Corporate Index optimized to have 2.5 years of duration. 15 Bloomberg Finance L.P. as of November 16, 2020 based on the yield and option adjusted duration figures for the Bloomberg Barclays US Aggregate Bond Index and the Bloomberg Barclays US Universal Bond 10+Year Index. 16 Bloomberg Finance L.P. as of November 16, 2020 based on the 20-year average for the option adjusted spread of the Bloomberg Barclays US Corporate High Yield Index. 17 J.P. Morgan Default Monitor, as of September 30, 2020. Loans default rates based on first lien loans data; note that first lien loans have represented over 95% of outstanding loans historically since 2005 (source: LCD). 18 Bloomberg Finance L.P. 11/18/2015 to 11/13/2020, based on weekly returns. S&P/LSTA US Leveraged Loan Index used to represent Senior Loans and S&P 500 Index used to represent Equities. The Bloomberg Barclays US Corporate High Yield Index. 19 Bloomberg Finance L.P. as of November 16, 2020 based on the index characteristics for the Bloomberg Barclays EM Local Currency Government Diversified Index. 20 Bloomberg Finance L.P. as of November 16, 2020 based on the index characteristics for the Bloomberg Barclays EM Local Currency Government Diversified Index. 21 Bloomberg Finance L.P. as of November 16, 2020 based on monthly returns between the Bloomberg Barclays EM Local Currency Government Diversified Index and the Bloomberg Barclays US Aggregate Bond Index from 11/15/2015 to 11/13/2020. 22 Bloomberg Finance L.P. as of November 16, 2020 based on monthly returns between the Bloomberg Barclays EM Local Currency Government Diversified Index and the MSCI EM Local Currency Index from October 2010 to October 2020. 23 Bloomberg Finance L.P. as of November 16, 2020 based on the Bloomberg Dollar Spot Index return from 5/15/2020 to 11/13/2020. 24 Bloomberg Finance L.P. as of November 16, 2020. 80% of the holdings within the Wells Fargo Hybrid Preferred Securities Index based on Bloomberg Composite Ratings of S&P, Moody’s Fitch, and DRBS ratings. 25 Bloomberg Finance L.P. as of November 16, 2020 based on the monthly returns of the Wells Fargo Hybrid and Preferred Securities Aggregate Index versus the Bloomberg Barclays US Aggregate Bond Index and S&P 500 Index from 11/15/2015 to 11/13/2020. 26 Bloomberg Finance L.P. as of November 16, 2020 67% of the Wells Fargo® Hybrid and Preferred Securities Aggregate Index is in Financials.
Basis Point (bps) A unit of measure for interest rates, investment performance, pricing of investment services and other percentages in finance. One basis point is equal to one-hundredth of 1 percent, or 0.01%.
Bloomberg Barclays EM Local Currency Government Diversified Index (Underlies SPDR ETF “EBND”) A benchmark designed to measure the performance of fixed-rate local currency sovereign debt of emerging market countries. The index includes government bonds issued by countries outside the US in local currencies that have a remaining maturity of one year or more. They must be rated B3/B-/B- or higher, be fixed-rate and have certain minimum amounts outstanding, depending on the currency denomination of the bonds.
Bloomberg Barclays US Aggregate Bond Index A benchmark that provides a measure of the performance of the U.S. dollar-denominated investment-grade bond market. The “Agg” includes investment-grade government bonds, investment-grade corporate bonds, mortgage pass-through securities, commercial mortgage-backed securities and asset-backed securities that are publicly for sale in the US.
Bloomberg Barclays U.S. Convertibles Liquid Bond Index An Index designed to represent the market of U.S. convertible securities, such as convertible bonds and convertible preferred stock. Convertible bonds are bonds that can be exchanged, at the option of the holder or issuer, for a specific number of shares of the issuer’s equity securities. Convertible preferred stock is preferred stock that includes an option for the holder to convert to common stock.
Bloomberg Barclays US Corporate Bond Index A fixed-income benchmark that measures the investment-grade, fixed-rate, taxable corporate bond market. It includes USD-denominated securities publicly issued by US and non-US industrial, utility and financial issuers.
Bloomberg Barclays US Corporate High Yield Index A fixed-income benchmark of US dollar-denominated, high-yield and fixed-rate corporate bonds. Securities are classified as high yield if the middle rating of Moody's, Fitch and S&P is Ba1/BB+/BB+ or below. Bonds from issuers with an emerging markets country of risk, based on Barclays EM country definition, are excluded.
Bloomberg Barclays US MBS Index A benchmark designed to measure the performance of the US agency mortgage pass-through segment of the U.S. investment-grade bond market. The term “U.S. agency mortgage pass-through security” refers to a category of pass-through securities backed by pools of mortgages and issued by US. government-sponsored agencies.
Bloomberg Barclays US Treasury Bond Index A benchmark of US dollar-denominated, fixed-rate, nominal debt issued by the US Treasury. Treasury bills are excluded by the maturity constraint, but are part of a separate Short Treasury Index.
MSCI ACWI Index, or MSCI All Country World Index A free-float weighted global equity index that includes companies in 23 emerging market countries and 23 developed market countries and is designed to be a proxy for most of the investable equities universe around the world.
Mortgage Backed Securities Pooled securities that are backed by mortgage loans. Agency mortgage-backed securities refer to securities backed by pools of mortgages issued by US government-sponsored enterprises such as Government National Mortgage Association (GNMA), Federal National Mortgage Association (FNMA) and Federal Home Loan Mortgage Corporation (FHLMC).
S&P/LSTA U.S. Leveraged Loan 100 Index A benchmark that is designed to reflect the largest loan facilities in the leveraged loan market. It mirrors the market-weighted performance of the largest institutional leveraged loans based upon market weightings, spreads, and interest payments. The index consists of 100 loan facilities drawn from a larger benchmark, the S&P/LSTA (Loan Syndications and Trading Association) Leveraged Loan Index (LLI).
Standard Deviation A statistical measure of volatility that quantifies the historical dispersion of a security, fund or index around an average. Investors use standard deviation to measure expected risk or volatility, and a higher standard deviation means the security has tended to show higher volatility or price swings in the past. As an example, for a normally distributed return series, about two-thirds of the time returns will be within 1 standard deviation of the average return.
Wells Fargo Hybrid and Preferred Securities Aggregate Index A modified market-capitalization-weighted benchmark designed to measure the performance of non-convertible preferred stock and securities that are equivalent to preferred stock. Constituents include depositary preferred securities, perpetual subordinated debt and some securities issued by banks and other financial institutions that are eligible for capital treatment.
Yield Curve A graph or line that plots the interest rates or yields of bonds with similar credit quality but different durations, typically from shortest to longest duration. When the yield curve is said to be “flat,” it means the difference in yields between bonds with shorter and longer durations is relatively narrow. When the yield curve is said to be “steep,” it means the difference in yields between bonds with shorter and longer durations is relatively wide.
Important Risk Discussion
The views expressed in this material are the views of Michael Arone and Matthew Bartolini through the period ended November 18, 2020 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.
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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.
Issuers of convertible securities may not be as financially strong as those issuing securities with higher credit ratings and may be more vulnerable to changes in the economy. Other risks associated with convertible bond investments include: Call risk which is the risk that bond issuers may repay securities with higher coupon or interest rates before the security's maturity date; liquidity risk which is the risk that certain types of investments may not be possible to sell the investment at any particular time or at an acceptable price; and investments in derivatives, which can be more sensitive to sudden fluctuations in interest rates or market prices, potential illiquidity of the markets, as well as potential loss of principal.
Investments in mortgage securities are subject to prepayment risk, which can limit the potential for gain during a declining interest rate environment and increase the potential for loss in a rising interest rate environment. The mortgage industry can also be significantly affected by regulatory changes, interest rate movements, home mortgage demand, refinancing activity, and residential delinquency trends.
The value of the debt securities may increase or decrease as a result of the following: market fluctuations, increases in interest rates, inability of issuers to repay principal and interest or illiquidity in the debt securities markets; the risk of low rates of return due to reinvestment of securities during periods of falling interest rates or repayment by issuers with higher coupon or interest rates; and/or the risk of low income due to falling interest rates. To the extent that interest rates rise, certain underlying obligations may be paid off substantially slower than originally anticipated and the value of those securities may fall sharply. This may result in a reduction in income from debt securities income.
Investments in Senior Loans are subject to credit risk and general investment risk. Credit risk refers to the possibility that the borrower of a Senior Loan will be unable and/or unwilling to make timely interest payments and/or repay the principal on its obligation. Default in the payment of interest or principal on a Senior Loan will result in a reduction in the value of the Senior Loan and consequently a reduction in the value of the Portfolio’s investments and a potential decrease in the net asset value (“NAV”) of the Portfolio.
An actively managed fund may underperform its benchmarks. An investment in the fund is not appropriate for all investors and is not intended to be a complete investment program. Investing in the fund involves risks, including the risk that investors may receive little or no return on the investment or that investors may lose part or even all of the investment.
Passively managed funds hold 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.
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