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.