Seek a balance between income generation, credit risk, equity risk and macro volatility by employing active strategies.
Bond market returns have rewarded patient investors so far this year, with US core aggregate bonds registering their best gain since 2011.1 However, the strong returns have come at the price of lower current income and yields, pushing interest rates below both their longer-term averages and levels from a year ago. This has forced investors to look elsewhere for yield, leading to a tightening of spreads for below-investment-grade credits — the major catalyst for high yield bonds’ current double-digit gains.2
With rates low, credit spreads tight, and equity markets at all-time highs, navigating the global capital markets for sustainable income will be increasingly challenging as we head into 2020. Additionally, if geopolitical noise alters sentiment in either direction, volatility could infiltrate the part of a portfolio that is designed to provide stability and mitigate downside risk.
Therefore, for 2020, generating sufficient levels of income within bond portfolios should be more about balancing duration, credit and geopolitical risks and less about reaching for double-digit returns again. While diversification cannot remove risk, but only transform it, active strategies that have the ability to rotate and pick up yield across bond sectors that are lowly correlated to one another may help to balance these risks in today’s “little room for error” environment.
Source: Bloomberg Finance L.P. as of 11/8/2019. Past performance is not a guarantee of future results. Global Aggregate: Bloomberg Barclays Global Aggregate Bond Index; U.S. Aggregate: Bloomberg Barclays US Aggregate Bond Index; U.S. Corporate: Bloomberg Barclays US Corporate Bond Index; U.S. Treasury: Bloomberg Barclays US Treasury Bond Index; Global Agg ex-US: Bloomberg Barclays Global Aggregate Bond Ex-US Index; Global ex-US Corporate: Bloomberg Barclays Global Corporate Bond Ex-US Index; Global High Yield: Bloomberg Barclays Global High Yield Bond Index; EM Hard Currency Aggregate: Bloomberg Barclays EM Hard Currency Aggregate Bond Index; U.S. MBS: Bloomberg Barclays US MBS Index.
With the Federal Reserve (Fed) on hold3 and still-slow growth dynamics constraining the long end of the curve,4 the yield curve is likely to slope upward but stay flat in 2020. Trading well below the recent three- and five-year averages of 0.54% and 0.82%, respectively,5 it should continue to reside within the tight range it has traded in since June of 2018.6
With a yield curve in stasis, as the base case view, lengthening duration may seem like the ideal allocation. However, overextending on duration may present an uncompensated risk. Low yields (i.e., low carry) are unable to fully act as a buffer and offset any duration-induced price losses if growth surprises or macro risks abate and the curve steepens. The gain/loss profile is also asymmetrical after the double-digit returns from long US Treasuries in 2019. For long US Treasuries to post double-digit returns again in 2020, long-term rates would have to fall by 170 basis points. That would equate to a yield of just 60 basis points based on today’s levels, and it would be the lowest long-term rate ever on record by 140 basis points.
As a result, long duration is a risk not worth taking — especially as some portions of the market provide a more balanced yield and duration profile. As shown below, the 1-10 year intermediate corporate market has a higher yield, but with much less duration than the Agg. Additionally, mortgage-backed securities (MBS) may present attractive opportunities given that with the Fed on hold, the pace of refinancing activity, which hit a three-year high this year, may now slow. With less refinancing activity, the recent underperformance relative to US Treasuries may reverse itself and allow investors to pick up 10% more yield, but with 45% less duration versus the Agg.
Source: Bloomberg Finance L.P. as of 11/8/2019. Past performance is not a guarantee of future results. 1-3 Year Corporate: Bloomberg Barclays US Corporate 1-3 Yr Index; 1-3 Year Treasury: Bloomberg Barclays Treasury: 1-3 Year Index; MBS: Bloomberg Barclays US MBS Index; 1-10 Year Corporate: Bloomberg Barclays Intermediate Corporate Index; 1-10 Year Treasury: Bloomberg Barclays US Intermediate Treasury Index; TIPS: Bloomberg Barclays US Treasury Inflation Notes Index; Aggregate: Bloomberg Barclays US Agg Index; Broad Investment Grade (IG) Corporate: Bloomberg Barclays US Corporate Index ; Broad Treasury: Bloomberg Barclays US Treasury Index; Long Corporate: Bloomberg Barclays Long Corporate Index; Long Treasury: Bloomberg Barclays US Long Treasury Index
While default rates7 have ticked up as a result of weakness in certain sectors, the spread compression in 2019 has put broad-based US corporate high yield spreads 30% below their long-term averages. While not at extremes, spreads remain expensive and indicate below-coupon returns based on historical trends.8 Also, the runup in values has led to a notable increase in high yield’s correlation to equities, as shown below, making it more susceptible to equity drawdowns.
Moreover, broad-based high yield bonds, as shown above, are also the most negatively convex they have ever been, indicating that there is less upside relative to downside. Further, in years after high yield produced double-digit returns, the subsequent year saw an average 60% decline in returns.9
High yield has a place in the portfolio, given the carry, but there are ways to generate similar levels of income while also transforming the risk profile. One option is to allocate a portion of high yield to senior loans, seeking to position a bit more defensively by moving up the capital structure. Another option is to target emerging market debt (EMD).
With EMD, the risk profile is transformed from credit to currency, as the major determinant of short-term EMD risk and return fluctuations typically forms as a result of currency trends.10 However, EMD is more susceptible to geopolitical macro shocks than other bond sectors. Depending on the outcome of one of the larger macro risks – trade – that risk may manifest itself in offsetting performance. A US-China trade deal would likely benefit EM, as it would reverse some of the US dollar’s strength built up over the past 18 months and ease currency pressures for several countries around the globe. Conversely, rate-sensitive sectors may be negatively impacted by a steepening yield curve, as a risk overhang has been removed from the market.
On the hunt for yield in 2020, balancing the sources of risk may be the most
beneficial strategy for the portion of portfolios that is mean to provide
income, stability, and diversification.
To create a bundled solution that leverages active management in the core, income and liquidity sleeves of a portfolio, consider these three types of mandates:
1 ) A core strategy that allocates across a multitude of bond sub-sectors aims to generate a higher yield than the Agg, but with a lower standard deviation of returns as a result of the potential sector diversification.
SPDR DoubleLine Total Return Tactical ETF combines traditional and non-traditional fixed income asset classes with the goal of maximizing total return over a full market cycle through active sector allocation and security selection.
2 ) A tactical income-focused strategy that rotates among high-income asset classes to potentially pick up cross-asset diversification benefits and seek higher-income opportunities based on market conditions.
SPDR SSGA Income Allocation ETF employs tactical allocations across asset classes that produce current income, including US government and corporate bonds; US convertible and preferred securities; global REITs; and domestic and international equities with a focus on dividends.
3 ) An ultra-short duration active strategy that can potentially take advantage of the flat curve and aims to generate a yield in excess of cash by allocating to more than just basic high-grade corporates and US Treasuries.
SPDR SSGA Ultra Short Term Bond ETF seeks to provide current income consistent with preservation of capital and daily liquidity through short duration high quality investments that may also be slightly longer-term securities than traditional cash vehicles as the fund seeks to generate a better total return.
Being active can take many forms, and with the advent of specific bond subsector ETF exposures, investors have the ability to precisely tailor bond portfolios for the year ahead and, based on their risk profile, create customized and flexible active tilts to broad-based Aggregate bonds.
To selectively alter portfolio profiles by modestly overweighting the sectors we feel represent attractive opportunities, consider these exposures:
1 Bloomberg Finance L.P. as of 11/8/2019 based on the performance of the Bloomberg Barclays US Aggregate Bond Index
2 Bloomberg Finance L.P. as of 11/8/2019 based on the performance of the ICE BofAML US High Yield Index
3 "Fed’s Powell says interest rates will be on hold absent a material deterioration in economy", MarketWatch November 13, 2019.
4 Adrian Crump & Moench 10-Year Treasury Term Premium Index is negative
5 Bloomberg Finance L.P. as of 11/8/2019.
6 With the exception of the drop in August to September, the yield curve has hovered around 20 basis points.
7 Default rates are 2.9%, compared with 1.9% at the start of the year, BAML High Yield Research 11/4/2019.
8 High yield spreads as of 11/8/2019 were 371 basis points. Per Bloomberg Finance L.P. data and SPDR Americas Research calculations, based on return and spread information dating back to 1999, when high yield spreads are within 350 to 400 basis points, the price return over the subsequent 12 months, on average, has been -2.5% with more than 100% of the return then coming from the coupon as the total return has been 4.4%.
9 Bloomberg Finance L.P. as of 11/8/2019 per SPDR Americas Research Calculations. Past performance is not a guarantee of future results.
10 Bloomberg Finance L.P. as of 10/31/2019 there is a 94% correlation between the monthly returns of the Bloomberg Barclays Emerging Markets Local Currency Liquid Government Index and the MSCI EM Local Currency Index Monthly Returns from 10/2009 to 10/2019.
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 Hard Currency Aggregate Bond Index
The Bloomberg Barclays Emerging Markets Hard Currency Aggregate Index is a flagship hard currency Emerging Markets debt benchmark that includes USD, EUR, and GBP-denominated debt from sovereign, quasi-sovereign, and corporate EM issuers.
Bloomberg Barclays Global Aggregate Bond Ex-USD Index
The Bloomberg Barclays Global Aggregate ex USD Index is a measure of investment grade debt from 24 local currency markets. This multi-currency benchmark includes treasury, government-related, corporate and securitized fixed-rate bonds from both developed and emerging markets issuers. Bonds issued in USD are excluded.
Bloomberg Barclays Global Aggregate Bond Index
A benchmark that provides a broad-based measure of the global investment-grade fixed income markets. The three major components of this index are the U.S. Aggregate, the Pan-European Aggregate, and the Asian-Pacific Aggregate Indices. The index also includes Eurodollar and Euro-Yen corporate bonds, Canadian government, agency and corporate securities, and USD investment-grade 144A securities.
Bloomberg Barclays Global High Yield Bond Index
The Bloomberg Barclays Global High Yield Index is a multi-currency flagship measure of the global high yield debt market. The index represents the union of the US High Yield, the Pan-European High Yield, and Emerging Markets (EM) Hard Currency High Yield Indices. The high yield and emerging markets sub-components are mutually exclusive.
Bloomberg Barclays Intermediate US Corporate Index
A benchmark designed to measure the performance of U.S. corporate bonds that have a maturity of greater than or equal to one year and less than 10 years.
Bloomberg Barclays Intermediate US Treasury Index
A benchmark designed to measure the performance of public obligations of the U.S. Treasury that have a remaining maturity of greater than or equal to 1 year and less than 10 years.
Bloomberg Barclays Long US 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 Long US Treasury Index
A benchmark that includes dollar-denominated publicly issued U.S. Treasury securities that have remaining maturity of 10 or more years. They must be rated investment-grade, have $250 million or more of outstanding face value and be fixed rate and non-convertible.
Bloomberg Barclays Treasury: 1-3 Year Index
The Bloomberg Barclays US Treasury: 1-3 Year Index measures US dollar-denominated, fixed-rate, nominal debt issued by the US Treasury with 1-2.999 years to maturity. Treasury bills are excluded by the maturity constraint, but are part of a separate Short Treasury Index. STRIPS are excluded from the index because their inclusion would result in double-counting.
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 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 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.
Bloomberg Barclays US Treasury Inflation Notes Index
The Bloomberg Barclays US 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 US 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 U.S. 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.
A given security’s potential to lose value if a prevailing market trend suddenly changes. The term also refers to the specific financial amount of the “worst case” loss that can occur in such a sudden shifts.
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 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.
The views expressed in this material are the views of Michael Arone and Matthew Bartolini through the period ended November 15, 2019 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.
The whole or any part of this work may not be reproduced, copied or transmitted or any of its contents disclosed to third parties without SSGA's express written consent.
All information has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. There is no representation or warranty as to the current accuracy, reliability or completeness of, nor liability for, decisions based on such information and it should not be relied on as such.
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.
State Street Global Advisors Funds Distributors, LLC is the distributor for some registered products on behalf of the advisor. SSGA Funds Management, Inc. has retained DoubleLine Capital LP as the sub-advisor. State Street Global Advisors Funds Distributors, LLC is not affiliated with DoubleLine Capital LP. SSGA Funds Management has retained GSO Capital Partners as the sub-advisor for SRLN. State Street Global Advisors Funds Distributors, LLC is not affiliated with GSO Capital Partners.