“Fifty Shades of Grey”: In defence of fixed income

Overview:

Fixed income is not a well understood asset class. This is partly because it’s “misnamed”, partly because of its relative complexity, and partly because of the diversity of approaches taken.  This is important context as there is plenty of debate about the role of fixed income and how investors should best access in their portfolios. It is though the things that make fixed income hard to understand that give it its enduring value.

This article will focus on this point. Even in an environment of rising interest rates, many of the concerns about fixed income are misguided and dramatically overstated. 

Context: The traditional role of defensive fixed income (theory & practice) 

We are in a world awash with fixed income investments. Outstanding global bond debt at around USD 130 trillion[1], is almost double that of the market capitalisation of the global equity market[2]. Fixed income assets make up a significant part of the global investment universe and can’t be ignored.

 How investors approach fixed income assets is an active choice, primarily driven by the role they expect it to play or the investment “problem” they are trying to solve. For example, for investors looking to accumulate wealth or to draw an income from their accumulated wealth (as distinct from say liability matching purposes in insurance based portfolios) fixed income assets are used in either of 2 ways:

–         In a defensive capacity (as a source of low risk return; for the diversification of risk (predominately equity risk); as a source of liquidity; the generation of income; and / or, to protect capital; and / or

–         In a growth oriented / return seeking role primarily utilising either the higher risk parts of the universe (global high yield, hybrids and subordinated securities) and comingled “absolute return” fixed income strategies that may also involve the use of both leverage and currency positions to generate absolute return outcomes.

The ability of fixed income to play these different roles in part reflects its diversity. This is reflected in a range of factors including: the type and quality of issuers (governments versus corporates), issuer quality (investment grade versus sub-investment grade, developed market debt versus emerging), the degree of subordination (senior secured debt versus hybrids & subordinated debt), security type (fixed rate versus floating rate), maturity, coupon, individual covenants etc. The list goes on. This is an important point because the current fixed income debate is primarily related to one particular aspect of the fixed income universe – namely the level of interest rates and in particular the impact (positive and negative) of duration. 

The defensive properties of fixed income come primarily from 2 sources:

–         the countercyclical nature of interest rates (they decline when economies slow or inflation slows); and

–         the underlying “quality” of the securities themselves, reflecting issuer quality, the relative seniority of debt in the corporate capital structure, the predictability of the income stream, and the fact that unlike equities which are effectively perpetual securities, fixed income securities generally (albeit not always) have fixed contractual maturities.

The primary driver of the idea that bonds can diversify equity risk in a cyclical sense (particularly under stress conditions) is related to the first of these factors – namely the interest rate sensitivity (or duration) of these securities. When economic conditions moderate central banks typically cut rates (or certainly expectations that rates will fall, rises) dragging down bond yields and boosting bond returns. Typically this is occurring at the same time that profits are slowing and equities are falling meaning returns to bonds are at least partially offsetting weakness in equities. Of course this is the theory and in practice it is never quite so pure with a raft of factors including starting point valuations, structural trends and unpredictable policy responses ensuring a less than perfect offset. 

Does this still hold? 

There are several arguments that have been put forward questioning how well fixed income can continue to play this defensive role. These are:

–         That the structural bond bull market of the last 30 years is coming to an end;

–         Inflation is rising and central banks (led by the US Federal Reserve) will need to raise official interest rates driving bond yields higher leading to investor losses (1994 still remains the “go to” reference period”);

–         The diversification benefit of holding both bonds and equities in a portfolio has broken down (given the impact of the structural bull market (and global QE) on both bond and equity prices;  

–         A lengthening of the duration of bond indexes has led to an increase in the interest sensitivity to changes in rates and credit spreads.

Below we consider the validity of these points and the conclusions that can be drawn from them. 

Structural versus cyclical risks 

There is some muddling here of the tension between cyclical and structural factors. Our research suggests that rising bond yields have their origins in cyclical, not structural, factors. Above trend growth has eroded spare capacity in product and labour markets (the US unemployment rate is well below the NAIRU) and as a consequence inflation pressures are rising and so too are rates. To date this is mainly in the US but other key economies appear to be following. It is possible that core inflation surprises and policy is caught napping which could cause a temporary spike in bond yields to territory not seen since pre-GFC, but this would still likely be low by historic standards. Naïve trend lines on long term charts are nearing break points – but these are prone to revision as the future unfolds. 

Structural parameters though continue to provide a more challenging perspective. High levels of debt, aging populations and muted productivity growth suggest limits on yields will be lower than in past cycles and persistently lower than in past cycles. In fact low yields are more the norm than the exception even though those whose investment experience encapsulates the 1970’s, 1980’s and 1990’s may have a different frame of reference. A final important caveat is that the next downturn / recession would potentially propel yields significantly lower than that of the last decade as the ability of policymakers to reflate, either through extreme fiscal or monetary experimentation. This downturn may not be as far away as some expect. 

Chinks in the diversification argument 

To the extent that central bank policy globally has been a major contributor to asset price gains, it is logical to argue that quantitative tightening and rising rates would also adversely impact asset prices and particularly those where actual or perceived financial leverage is an important driver (such as REIT’s and infrastructure). What this argument omits is the impact on these other assets is likely to be much more pronounced than on bonds themselves so it is these other assets that require a significant rethink of positioning. 

While much is made of the bond / equity correlation, history suggests that this relationship is not as pronounced or constant as is assumed. In fact, a negative correlation between bonds and equities is actually a relatively recent phenomenon (roughly the last 15 years) and in reality has been slightly positive (on average) for the last 115 years. Moreover, in the US the historical range has been wide, ranging from +0.8 and -0.8. It’s been a similar story for Australia. Clearly not a relationship than can be relied upon without more thought. 

The high correlation in the 1980’s and 1990’s is largely due to the impact of structural disinflation which fuelled a multi-decade bull market in bonds as inflation moderated and a consequent re-rating of equity markets to reflect lower inflation. If we exclude this period the average correlation between bonds and equities falls sharply.

Figure 1: US & Australian Bond / Stock Correlations

Source: Schroders, Global Financial Data 

An important perspective on diversification is that it doesn’t matter that much in normal markets. Diversification matters most in periods of market stress where risk asset correlations tend to converge and liquidity moderates. In most circumstances, when risk assets falter, bonds will outperform. While we are not forecasting imminent collapse, risk assets are vulnerable – particularly as any downturn in growth (or worse still recession), would rapidly reinstate deflation concerns and it wasn’t that long ago (early 2016) when this was the market’s central assumption. The future is and remains uncertain. Moreover, markets can adjust quickly (and often quicker than investors can respond). We only have to look at the post Trump US election experience to see how far and fast yields can change. This is often quicker than portfolios can respond and likely unpredictable in the shorter run given how difficult the catalysts are to know ahead of time (hindsight is a wonderful thing). 

Perhaps most importantly for investors is the question of how the bond / equity correlation behaves in stress environments (those typically characterised by falling equity markets). On this point we can observe a stronger negative correlation. This is highlighted in figure 2. While bond returns were positive in 8 out of 11 of these episodes (and averaged +5.9% across all these periods), even in the 3 episodes of negative returns, the negative returns were minor in comparison to the substantial declines in equities. The annualised returns account for the fact that these drawdowns were of different durations (from 3 months to almost 3 years). Notable though on this basis is the relatively consistent and significant outperformance of bonds. 

Figure 2: Drawdowns of greater than 25% in US equities[3]

Source: Schroders, Global Financial Data.  Analysis is based on monthly returns from 1919 to April 218

While bond drawdowns do occur as interest rates fluctuate, drawdowns are typically short and modest in size. Figure 4 compares the biggest equity drawdowns to the biggest bond drawdowns (here we are using the US 10 Year which would typically be longer duration than most investors would hold). Significantly it shows both relatively modest drawdowns and a very short period of time before investors are back to square – in stark contrast to that of equities. This reflects the contribution of coupons / income to the return and impact of reinvestment at higher effective rates. 

Figure 4: 10 worst drawdowns and time to recovery

Source: Schroders, Global Financial Data

 What about the Australian experience? 

The universal diversification benefits of bonds in stressed markets applies equally for Australian investors where we can examine the performance of the Bloomberg Ausbond Composite 0+ Bond Index versus the S&P/ASX200.   This composite bond index is shorter duration than a 10 year bond and includes credit but would be a bit more reflective of what investors would actually own in their portfolios (rather than a 10 year bond which investors typically don’t hold).   Although the performance history is shorter, we see in Figure 5 a consistent pattern of bonds outperforming when equities experience negative returns and the contributions of bonds to a portfolio increases as the equity returns get worse. 

Figure 5: Australian bond performance during periods when equities delivered negative returns

Source: Schroders, Bloomberg. Past performance is not an indicator of future performance

Challenges with bond benchmarks 

Bond benchmarks are predominately market cap based. As noted above debt levels remain high and it’s logical in a low and arguably distorted rate environment that borrowers lock in low rates for as long as possible. While this may not always be in the interests of bond investors, central bank actions have tended to align benchmark characteristics more in favour of borrowers than lenders. For example, the main Australian benchmark portfolio (Bloomberg Composite 0+ Bond Index) has lengthened in duration terms from 3.5 years to circa 5.0 years (an increase in duration of almost 50%) while becoming less diversified as the share of corporate debt has shrunk over the same time from around 1/3 of the index to around 11% currently. 

These changes are significant as they mean that the index portfolio is both significantly more sensitive to change in interest rates and is less able to see interest rate effects mitigated by changes in credit spreads as credit represents a significantly smaller exposure. For investors where focus is on the avoidance / mitigation of losses, consequences are profound. As figure 6 shows, whereas in 2011 an investor who held the index portfolio would have needed to see yields rise by over 1.5% to erode income and produce a negative return over a 12 month period, today the equivalent change in yields is 0.4% - around 25% of the change needed just 5 years ago. 

Figure 6: Rise in yields to generate a 0% return for an investor holding the benchmark portfolio

Source: Bloomberg, Schroders

It is important to distinguish here the lengthening of benchmark duration by default, and the structural benefits of having an appropriate level of duration in a portfolio. They are not one and the same. Managing how much duration is in a portfolio is critical to determining the right level of interest rate risk in a portfolio. This is clearly an argument for active management of fixed income. 

A reality check – are we too late? 

We have already seen a significant sell-off in US bonds. US 10 year bond yields touched 1.36% in early July 2016, and have more than doubled to be just over 3% (as at 15 May 2018). The sell-off has been quite pronounced across the yield curve with US 2 Year bond yields rising by almost five-fold (+0.55% to +2.57%) and US 5 Year bond yields rising three-fold (+0.95% to +2.92%). 

While there is still upside to yields, investors need to recognise that significant repricing has already occurred. The risks around US treasury yields while in our view are still to the upside, would appear to be significantly more asymmetric than they have been at any time in the last few years.  Secondly, the brunt of this change in yields on performance have been felt in longer dated bonds (10Y+) and (interestingly) in bond proxies like REIT’s. More diverse and shorter duration exposures have not been immune, but have not been impacted to the downside to anywhere near the same extent. This reinforces an earlier point that the diversity of the fixed income universe is one of its key strengths. 

Figure 7: US asset class returns since low in bond yields July 2016

Source: Schroders, Datastream. Returns are from 31 July 2016 to 15 May 2018. Past performance is not an indicator of future performance

This also highlights the tendency for investor overreaction to the threat of rising yields and the different perspective investors have for tolerating low / negative returns from fixed income when compared to equities. 

Conclusion 

–         Our base case is that bond yields rise from current levels reflecting rising inflation and steps towards more “normal” global policy settings. As a consequence managing duration exposure is (as always) important.

–         We also expect modest returns from fixed income, including the potential for negative returns in the short run.

–         That said, the downside risks to fixed income returns are overhyped and overstated. Firstly because we believe investors are muddling structural and cyclical arguments, and secondly because of the diverse nature of the asset class itself.

–         We challenge the assumption that fixed income’s ability to diversify equity risk has broken down. Should growth falter and recession risk rise, fixed income will be the place to be.