We have been arguing for some time that the economy has entered the later stage of the economic expansion and global growth will keep synching lower. At the same time, we expect the equity volatility we saw in Q4 2018 to remain a feature of markets. In this environment, allocations for 2019 appear to be shifting toward bonds, yet many investors continue to search for yield, aiming to “squeeze” out the last bit of return in the late stages of the economic cycle. As a result, these investors may not look beyond the headline yield or distribution rate to understand the risks of the bond funds they are investing in and whether those risks are appropriate for their desired investment profile given market conditions.
It is important to note that not all fixed income funds are created equal. Some bond funds can be effective in helping investors manage higher volatility and market risk while generating attractive income. Others may invest heavily in segments of the fixed income market that have higher correlations to riskier assets, such as equities, and may not be as defensive as investors would expect during periods of heightened market volatility. Some bond funds also tend to have structural credit biases, whereas others employ more flexibility across fixed income sectors.
In today’s more volatile environment where returns across asset classes are likely to be lower, analyzing the risks of your fixed income allocation is more important than ever.
A lesson from history: Not all fixed income funds performed well in the global financial crisis (GFC)
Recency bias often results in investors following a similar investment strategy to one that worked in recent time periods. This includes allocating to riskier segments of the market that have generally performed well in recent years due to a recovering economy in a period with historically low volatility. However, we believe investors should consider the risks of such an approach in a late-cycle environment.
Fixed income isn’t a homogenous asset class. It runs the full spectrum from lower-risk sovereign bonds (e.g. U.S. Treasuries) to high yield bonds, which offer higher yield for a reason – they also entail much higher credit risk. Unsurprisingly, different asset classes within fixed income perform very differently depending on the stage of the economic cycle.
One notable case study is the late cycle environment of 2006-2008. Investors who were chasing higher yield by investing in riskier segments of the bond markets were most likely surprised by the performance of their fixed income portfolio during the GFC. For example, funds that were highly exposed to lower-rated credit delivered negative returns and didn’t prove to be the portfolio anchor that investors might have expected from a fixed income allocation (see Figure 1). Some investors may ultimately have experienced permanent impairment to their portfolios due to taking unintended risks. Similarly, those who were heavily invested in high yield bonds during the 2015 energy crisis would have experienced negative performance in their portfolios.
The same applies today as volatility continues to affect markets
The fourth quarter of 2018 really highlights the point that not all fixed income funds perform the same way in more volatile market conditions. As Figure 2 shows, funds that had a higher structural bias to lower-rated credit or riskier assets would have performed worse than more conservative funds that had a broad allocation across the fixed income spectrum with a mixture of global bonds and higher-rated credit.
As we come toward the end of this economic cycle, we are seeing typical late-cycle investment trends with investors seeking out the highest yielding portfolio or distribution rate. At the same time, after a period of unusual calm in markets, volatility is on the upswing and investors should be considering the inherent risks in their portfolios. Markets and investors have become used to a low volatility environment over recent years. However, as we noted in a recent blog, the higher volatility in late 2018 was actually in line with historical averages, while 2017 saw the second-lowest realized volatility since 1929 and should not be considered a “normal” environment (see Figure 3).
Manager and fund selection crucial to managing risk
We recommend investors carefully review their fixed income funds and asset managers to determine if any style bias exists and whether this style is prudent for today’s market conditions. As discussed, some asset managers run a structural bias to lower-rated credit and riskier assets, whereas others employ a broader and more flexible strategy over the cycle.
While we believe there is a place for credit in portfolios alongside core fixed income allocations, we would note some factors that are important when investing in more credit-oriented strategies:
- Top-down view: Having a robust macroeconomic process to properly analyze market risks and forecast forward-looking economic conditions
- Fundamental screen: Investing significant resources to properly analyze underlying investments and generate bottom-up investment ideas
- Valuation screen: Applying flexibility in managing portfolios to ensure that each investment delivers sufficient compensation for its underlying risk
- Technical screen: Having a robust understanding of underlying issuance trends across sectors and geographies to understand potential tailwinds or headwinds to investment performance.
In the same way that equity investors consider the differences between growth, value, cyclical or defensive stocks, bond investors should analyze their fixed income investments and assess whether they fit their risk profile. Ultimately, higher yields and distribution rates often result in riskier investments, and during periods of market volatility and stress the exit doors of those investments are almost always narrower than the entrance doors.
Against the backdrop of an aging economic expansion, we believe that now is an opportune time to achieve diversification while potentially boosting returns through greater allocation to core bonds. Learn our views in this recent blog post.
