The global COVID-19 crisis 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 levels we have never seen before. Yes, after the Global Financial Crisis (GFC), central bank rates went to zero – or near zero. But, for the decade after the GFC, the US 10- and 30-year rates averaged around 2.3% and 3.2%, respectively.1 Today, they are just 0.94% and 1.56%, with the yield on the broader Bloomberg Barclays US Aggregate Bond Index (Agg) hovering around 1.7%.2
As a result, structuring fixed income portfolios in and out of the core now requires a more tailored approach in order to meet specific return objectives and provide the necessary 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. And this makes sense, as 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 time of purchase for the Agg is 93%, with the five- and ten-year figures at 98%.3 As shown below, 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 today’s interest rates has led to notable duration-induced price appreciation – core Agg bonds are up 7% 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 and GFC). In fact, the relationship has already started to mean revert.
With the current yield environment at a record low (1.19%)5 for core bond sectors, based on the relationship above, investors could, therefore, expect a similarly low annualized return (i.e., around 1%) from core bonds over the next three to five years. Yet, the low return is not being met by lower risk. The duration of the 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 1.42% capital loss, as the yield today is far too low to offset any impact duration has on price.7 The risk/return profile is asymmetrical, and that is an issue for an exposure that is meant to comprise a large part of an investor’s portfolio.
Where to go for income in our new abnormal
To generate income for portfolio needs, investors must outlay more risk – either through duration (long-term Treasuries), equity (high-yield dividend stocks) or credit (high-yield bonds). Adding duration is likely unattractive, as extending out to long-term core bonds only results in a 1.5 percentage point increase in yield – but a 10-year extension of duration.8 With little uplift in yield — but a big increase in rate risk — that risk/return trade-off is vastly asymmetrical. As a result, in these types of situations, adding ancillary bond segments to the core may be more optimal, potentially providing both income and diversifcation benefits. For instance, high-income bond segments — such as high-yield bonds, senior loans, preferreds and emerging market (EM) debt — are historically less sensitive to — and correlated with — equities and traditional core bonds – but all carry a yield north of 3.5%.9
Given the increase in fixed income ETFs, investors can now precisely customize their fixed income exposure based on specific risk and return contraints. The table below shows how investors can pursue increased income potential from a traditional fixed income portfolio. Half of this illustrative portfolio is equally allocated to an array of nontraditional bond sectors of senior loans, high yield bonds, preferred stocks, and EM debt, with the other half allocated to traditional interest rate-sensitive core bonds. This results in a balanced profile between interest rate- and credit-sensitive segments that may still provide the necessary diversification to the equity side of the overall portfolio. Those core bonds can be further refined by disaggregating the components by maturity and subsector to target a higher yield, as discused in detail here. For this portfolio, the table below illustrates the constraints on the core Agg section.
The composure of the portfolio leads to a yield of 3% – a figure 180 percentage points greater than the Agg – with duration being reduced by 1.3 years. Yet, even with the credit risk added, the overall credit spread level is not significantly higher than you would find in just investment-grade bonds (120 basis points).10
In summary, the phrase “back to a low-rate environment” is just not true. The 2010’s low-rate world never featured the US 10-year at 0.88%, nor a rate below 1.5% for the broader Agg. As a result, generating income requires today’s investors to take on duration, credit, or currency risk. In our view, targeting high yield, senior loans, EM debt, and preferreds may be one path investors want to consider.
1 Bloomberg Finance L.P. as of October 30, 2020 based on rate levels from 12/2009 to 12/2019.
2 Bloomberg Finance L.P. as of November 9 2020.
3 Bloomberg Finance L.P. as of October 30, 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 9, 2020.
5 Bloomberg Finance L.P. as of November 9, 2020 based on the yield to worst for the Bloomberg Barclays US Aggregate Bond Index.
6 Bloomberg Finance L.P. as of November 9, 2020 based on the option-adjusted 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) + 1.58% =-1.42%.
8 Bloomberg Finance L.P. as of November 5, 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.
9 FactSet, 09/30/2015-09/30/2020. Five-year correlation of High Yield, Preferreds, Senior Loans, and EM Local Debt to the Agg is 0.34, 0.40, 0.02 and 0.30, respectively. Five-year beta of High Yield, Preferreds, Senior Loans and EM Local Debt to the S&P 500 is 0.37, 0.30, 0.29, and 0.32. High Yield yield is 4.93%, Senior Loans yield to worst is 4.7%, Preferreds yield is 5.47%, and EM Local Debt yield 3.6% per Bloomberg Finance L.P. as of November 5, 2020. EM Local Debt = Bloomberg Barclays EM Local Currency Government Diversified Index. Senior Loans = S&P/LSTA US Leveraged Loan 100 Index. Preferreds = Wells Fargo Hybrid and Preferred Securities Aggregate Index. High yield = Bloomberg Barclays US Corporate High Yield Index.
10 Based on the Bloomberg Barclays US Corporate Bond Index as of November 5, 2020.
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.
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