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].