Three Ideas for More Resilient Fixed Income Portfolios
Seek Relative Value in Rates
Central banks have returned to Great Financial Crisis (GFC)-era monetary stimulus tools to reassure the market and inject much-needed liquidity. While the COVID-19 global pandemic is unprecedented, the policy responses are similar, and insights can be gleaned from the past. Following the GFC, inflation began increasing as a result of the stimulus measures – averaging 2.4% from 2009 until 2012 – after a demand-driven deflation shock began in 2008. One could reasonably expect the same trend today – given the potential for the price tag of the monetary and fiscal stimulus plans (approximately $6 trillion)1 to fuel an economic rebound2 later in the year, once the COVID-19 curve has flattened. Therefore, investors may consider potential relative value opportunities in the rates markets, swapping nominal US Treasuries for inflation-protected Treasuries – legging into the trade over the next quarter, as data have yet to reflect the demand-driven deflation shock.
How to Implement
As shown above, as inflation rose post the GFC crisis, Treasury Inflation-Protected Securities (TIPS) began to outpace nominal US Treasuries. From mid-2009 through 2012, TIPS outperformed nominals in 60% of the months, by an average of 30 basis points.3 Outside of any ability to go long/short, swapping nominal exposure for TIPS may be the most efficient way to capture this premium – either completely or through a blend (i.e., 50%/50%). Adding TIPS without reducing nominal exposure may unintentionally extend a portfolio’s duration profile and dilute the potential relative value opportunity, as duration effects will be the predominant driver of risk and return of this trade. After all, TIPS are still bonds.
For TIPS exposure, investors may consider the SPDR Portfolio TIPS ETF [SPIP].
Don’t Fight the Fed – Part 1: Adopt a Mortgage Bias
The Wall Street mantra “Don’t fight the Fed” refers to the notion that investors can do well by investing in a way that aligns with current monetary policies of the Federal Reserve (Fed). 4 To counter the current crisis, the Fed will be purchasing agency mortgage-backed securities (MBS) as stimulus tools, similar to what it did in the GFC. While the initial purchase amount was set at least $200 billion, a March 23 release indicated that the Fed would buy what is needed to support the economy. In other words, the Fed will conduct unlimited quantitative easing (QE). 5 Beyond having a large, constant buyer that will likely support a steady “bid” on the asset class, MBS have a structurally unique yield per unit of risk exposure, as shown below, that may prove beneficial in today’s uncertain environment.
How to Implement
Although the GFC was a housing-related crisis, agency MBS (+20.3%) actually outperformed US Treasuries (+19.6%), the Agg (+19.3%), and IG Corporates (+18.0%) with less drawdown risk,6 as default risks were, and still are, negligible. 7 The GFC returns shown above should diminish any concern over how a downturn in the housing market could impact the agency MBS market during the current crisis. Moreover, since volatility spiked, agency MBS (+2.2%) have outperformed the Agg (+0.8%) and IG Corporates (-7.1%).8 As we venture further into an uncertain 2020, follow the Fed’s plan on asset purchases; an overweight to MBS in broad portfolios may help to balance risk (rate and credit) in the hunt for yield.
For agency MBS exposure, investors may consider the SPDR Portfolio Mortgage Backed Bond ETF [SPMB].
Don’t Fight the Fed – Part 2: Shorten Credit Curve Exposure
Part of the Fed’s stimulus arsenal to combat the current crisis is to extend liquidity and capital to corporate borrowers by purchasing individual bonds of US investment-grade-rated firms with a maturity of five years or less as well as broad corporate bond ETFs. Back-of-the-envelope math using the Fed’s outlined constraint of being able to purchase only 20% of an ETF’s assets indicates that roughly $30 billion of corporate bond fixed income ETFs could be purchased9 – meaning that $220 billion of short-term corporate bonds could be bought.10 Similar to agency MBS, short-term corporate bonds will have the Fed supplying a supportive bid. As shown below, relative to other parts of the credit curve, the short-term segment witnessed a larger relative increase in spreads during recent volatility – but also snapped back faster following the Fed’s asset purchase announcement.
How to Implement
Broad investment-grade corporate bonds posted their worst quarterly loss since 2008. And looking ahead to the next two quarters, risks are skewed to the downside – even with the supportive stimulus actions – given that we are likely to see an uptick in rating downgrades, depressed earnings, and weak economic data. While ETF purchases are likely to support broader tenors, the more sizable and targeted stimulus actions will have a greater impact on the short end. As a result, allocating alongside the Fed and overweighting the short-term segment may help to balance yield and credit risks within a portfolio’s corporate exposure, particularly if future stresses emerge and the size of the program increases.
For short-term IG corporate credit exposure, investors may consider the SPDR Portfolio Short Term Corporate Bond ETF [SPSB].
1 “Kudlow Projects Coronavirus Aid Package to Reach ‘Roughly’ $6 Trillion”, National Review 3/24/2020. 2 Economic forecasts indicate negative growth in Q1 and Q2 and a rebound in Q3, based on consensus economic estimates, Bloomberg Finance L.P. as of 03/31/2020. 3 Bloomberg Finance L.P. as of 03/31/2020, calculations by SPDR Americas Research. 4 What is the Meaning of 'Don't Fight the Fed'? www.thebalance.com. 5 “Fed Unveils Unlimited QE and Aid for Businesses, States”, Bloomberg 3/23/2020. 6 Bloomberg Finance L.P. Performance from 12/31/2007 to 12/31/2009 as measured by the performance of the Bloomberg Barclays US Securitized Index (MBS), Bloomberg Barclays US Treasury Index (US Treasuries), Bloomberg Barclays US Aggregate Bond Index (the Agg), and the Bloomberg Barclays US Corporate Bond Index (IG Corporates). Drawdowns during the period were (-4.2%, -7.2%, -5.1%, and -16.0% respectively). 7 Agency MBS either have the explicit backing of the federal government (Ginnie Maes) or the implicit backing from the government-sponsored entities (GSEs) Fannie Mae and Freddie Mac. 8 MBS +2.2%, Agg +0.8%, IG Corporates -7.1% per Bloomberg Finance L.P. as of 03/31/2020 from 2/21/2020 to 3/31/2020. 9 Calculations based on removing any active, non-US focused corporate bond ETFs then applying a 20% constraint to the current asset levels. 10The program is the Federal Reserve Secondary Market Corporate Credit Facility (SMCCF), and has $25 billion of capital allocated by the US Treasury. The Fed can, however, lend roughly ten times what it holds in collateral for non-government securities, meaning the size of the program could be as large as $250 billion.
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 Long U.S. Corporate Index
A benchmark designed to measure the performance of U.S. corporate bonds that have a maturity of greater than or equal to 10 years.
Bloomberg Barclays U.S. Aggregate Bond Index
A benchmark that provides a measure of the performance of the US 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. 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 U.S. 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 “US 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 U.S. Treasury Bond Index
A benchmark of US dollar-denominated, fixed-rate, nominal debt issued by the U.S. Treasury. Treasury bills are excluded by the maturity constraint, but are part of a separate Short Treasury Index.
Bloomberg Barclays U.S. Treasury Inflation Notes Index
The Bloomberg Barclays U.S. Treasury Inflation-Linked Bond Index (Series-L) measures the performance of the US Treasury Inflation Protected Securities (TIPS) market. Federal Reserve holdings of US TIPS are not index eligible and are excluded from the face amount outstanding of each bond in the index.
Bloomberg Barclays U.S. 1–3 Year Corporate Bond Index
A benchmark designed to measure the performance of the short-term U.S. corporate bond market. It includes publicly issued US dollar-denominated and investment-grade corporate issues that have a remaining maturity of greater than or equal to one year and less than three years.
Consumer Price Index, or CPI
A widely used measure of inflation at the consumer level that helps evaluate changes in cost of living. The CPI is composed of a basket of consumer goods and services across the economy and is calculated by the US Department of Labor by assessing price changes in the basket of goods and services and averaging them.
The difference in yield between a U.S. Treasury bond and a debt security with the same maturity but of lesser quality.
A specific decline in the stock market during a specific time period that is measured in percentage terms as a peak-to-trough move.
A commonly used measure, expressed in years, that measures the sensitivity of the price of a bond or a fixed-income portfolio to changes in interest rates or interest-rate expectations. The greater the duration, the greater the sensitivity to interest rates changes, and vice versa. Specifically, the specific duration figure indicates, on a percentage basis, by how much a portfolio of bonds will rise or fall when interest rates shift by 1 percentage point.
Global Financial Crisis (GFC)
The economic upheaval of 2007-2009 that is generally considered the largest downturn since the Great Depression of the 1930s. The GFC was triggered largely by the sub-prime mortgage crisis that led to the collapse of systemically vital US investment banks such as Bear Stearns and Lehman Brothers. An aggravating factor was the speculative spike in energy that lifted oil prices to almost $150 a barrel in the summer of 2008, and which surely contributed to the economic slowdown.
A fixed-income security, such as a corporate or municipal bond, that has a relatively low risk of default. Bond-rating firms, such as Standard & Poor’s, use different lettered descriptions to identify a bond’s credit quality. In S&P’s system, investment-grade credits include those with ‘AAA’ or ‘AA’ ratings (high credit quality), as well as ‘A’ and ‘BBB” (medium credit quality). Anything below this ‘BBB’ rating is considered non-investment grade.
The degree to which an asset or security can be bought or sold in the market without affecting the asset’s price. Liquidity is characterized by a high level of trading activity.
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).
Quantitative Easing, or QE
An extraordinary monetary policy measure in which a central bank buys government fixed-income securities to lower interest rates, encourage borrowing and stimulate economic activity. Quantitative easing is considered when short-term interest rates are at or approaching zero, and does not involve the printing of new banknotes. Quantitative easing increases the money supply by flooding financial institutions with capital in an effort to promote increased lending and liquidity.
TIPS, or Treasury Inflation Protected Securities
Treasury inflation protected securities (TIPS) refer to Treasury securities that are indexed to inflation in order to protect investors from the negative effects of inflation. TIPS are backed by the US government and are thus considered an extremely low-risk investment. The par value of TIPS rises with inflation, as measured by the Consumer Price Index, while the interest rate remains fixed.
The debt obligations of a national government. Also known as "government securities," Treasuries are backed by the credit and taxing power of a country, and are thus regarded as having relatively little or no risk of default.
The income produced by an investment, typically calculated as the interest received annually divided by the price of the investment. Yield comes from interest-bearing securities, such as bonds and dividend-paying stocks.
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The views expressed in this material are the views of Matthew Bartolini through the period ended April 14th, 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 rise, 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.
Non-diversified funds that focus on a relatively small number of securities tend to be more volatile than diversified funds and the market as a whole.
Increase in real interest rates can cause the price of inflation-protected debt securities to decrease. Interest payments on inflation-protected debt securities can be unpredictable.
Investments in asset backed and mortgage backed securities are subject to prepayment risk which can limit the potential for gain during a declining interest rate environment and increases the potential for loss in a rising interest rate environment.
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