After seemingly defying the increasingly loud call of the bears for so long, bond markets finally sold off in the last quarter of 2016. Initially, the sell-off occurred in anticipation of the rate rise in the US, but it continued throughout the quarter in response to a couple of notable events.
One was Donald Trump’s surprise win in the US presidential election, as markets anticipated that his proposed fiscal initiatives would be inflationary. The other was more hawkish comments (i.e., the mention of three rather than two rate hikes in 2017) by the Fed after the rate rise in early December, surprising markets. The sell-off resulted in the Barclays Capital Global Aggregate Bond Index (a common global bond benchmark) suffering its worst monthly return since its inception in early ’90s. The Bloomberg AusBond Composite Index (a proxy for the Australian bond market) had its worst quarterly return since June 1994, with a return of -2.86 per cent.
As a consequence of the sell-off, media headlines abounded proffering doomsday scenarios and calling the end of the 30-year bull market for bonds. Understandably, many investors have expressed concerns about their exposure to this supposed ticking time bomb. I’m not brave enough to opine on whether we’ve seen the secular lows for bond yields, as I will leave this to well-known industry luminaries, such as Bill Gross with Janus and Jeffrey Gundlach at DoubleLine Capital. However, as can be seen in Table 1, the US 10-year Treasury yield chart, it’s safe to say bonds have had a good run for a long period.
The purpose of this article is to shed some perspective on the recent moves, remind investors of the qualities and characteristics of fixed income and demonstrate that the asset class still deserves a place in portfolios.
Despite all the media attention, it’s important to have some perspective on the sell-off in yields.
At the end of the quarter, US and Aussie government bond yields were roughly back to where they started 2016 – US 10-year government bond yields were 0.18 per cent higher, while their Australian counterparts were 0.19 per cent lower. Relative to equities, the quarterly sell-off was a mere blip. Equities experience negative daily moves of this magnitude frequently. In fact, the worst quarterly return for the S&P/ASX 300 Accumulation Index during the downturn in 2007-08 was about -19 per cent. While you shouldn’t expect this type of equity-like drawdown from your fixed income allocation, occasional drawdowns shouldn’t be unexpected. After all, fixed income isn’t riskless, it’s just less risky than equities (the extent to which varies within the asset class; more on this below).
A lot of the fear about fixed income appears to stem from the perceived complexity of the asset class. As a result, there’s much trepidation from advisers about using fixed income, as the task of explaining any negative numbers to clients becomes too onerous.
In fact, the most common feedback Zenith receives from clients in regards to the defensive portfolio allocations is “just don’t lose money”. While I’m not going to launch into a tutorial on bond basics, at their simplest, fixed-income assets are loans to governments, corporations and individuals. The loans/bonds pay income (known as coupons) at
regular, pre-determined intervals with principal repaid by the borrowers at maturity of the loan.
Brokers and analysts will frequently use a methodology known as discounted cash flow (DCF) to value companies. A similar approach is used to value fixed income securities, with the coupons and final value known with certainty at issuance (assuming no default), unlike equities. The factor that complicates the valuation is that interest rates change over the life of the loan, so the valuation adjusts to reflect this. Just as in a DCF equity model, rising interest rates make the fixed, known payments less valuable, and vice-versa. It’s this characteristic, interest rate sensitivity – also known as duration – that everyone is focused on at the moment. However, duration isn’t necessarily a bad quality (more on this below) and investors need to remember that if held to maturity, the quantum of the coupons and returned principal are constant and known with certainty.
All the focus at the moment is on government bonds, but it’s important to remember that fixed income isn’t a homogeneous asset class. There are multiple sub-sectors, each of which has its unique characteristics. While they all have some sensitivity to interest rate movements, the extent varies and it’s not always a negative relationship; for example, bank loans are floating rate, sub-investment debt that typically pays monthly coupons that will adjust up with rising interest rates. Table 3 highlights how divergent the performance of various sub-sectors can be over various periods, in Australian-dollar (top % figure) and local-currency (bottom % figure) terms.
It’s worth highlighting that despite the rise in yields over the last quarter, credit spreads continued to tighten, with high yield (HY) the standout performer.
Of course, the returns displayed above ignore the volatility and drawdown characteristics of the sub-sectors. While HY, emerging market (EM) debt and investment grade (IG) credit have delivered the
best long-term returns, they also have experienced higher commensurate volatility and drawdowns.
The point of the above is to remind investors
that fixed income is broader than just government bonds. By assuming a holistic approach to the asset class and allocating to those active managers with the ability and requisite skill in sector rotation, investors can minimise the impact of any sell-off in government bonds.
Duration in government bonds has historically played an important role in portfolios. As can be seen in Table 2, US government bonds (Treasuries) have tended to be negatively correlated to US equities
in times of market stress (grey-shaded areas). Admittedly, correlations vary over time and don’t always behave when you need them the most. However, there’s an intuitive reason why bonds behave this way that should result in this pattern continuing in the future. Firstly, central banks have a reactive function that leads them to cut cash rates – or launch additional quantitative easing in more recent times – in times of extreme stress. Additionally, investors still view government bonds as safe havens (guaranteed return of capital) in times of market stress. This pushes down yields and consequently results in price appreciation, which offsets losses in equities.
There are few asset classes where this negative correlation can be relied upon; hence the diversification benefits bonds afford shouldn’t be ignored. Zenith recognises that given where cash rates are around the world, the benefits of duration are likely to be less than what has been the case historically. However, if one rolled back to June 30, 2016, global bonds had returned more than 9 per cent (in Australian dollars) for the year at that time, despite the index having a starting yield of less than 2 per cent (pre hedging back to Australian dollars). While Zenith doesn’t advocate fully exposing the defensive part of client portfolios to duration, we still view it as an important component of a properly diversified portfolio.