A Silver Lining for Bonds
A recent conversation with an institutional client highlighted a couple of things that may be on the minds of some people:
- Should I get completely out of bonds?
- Will higher rates hurt my portfolio?
These are excellent questions. The answers are ‘maybe’ and ‘it depends,’ since, obviously, portfolios are not all designed the same.
We believe that the outlook for bonds (in general) is not as grim as it may appear. This is especially so for those who are attuned to the changes in the bond market, as well as for those investors who are highly diversified.
Below are some of the reasons we think there is a silver lining for bonds, even if rates move higher.
Relationship Between Stocks and Bonds
High quality bonds, whether treasuries or investment-grade corporate bonds, have proven over the last several years to be good hedges against equity drawdowns. Admittedly, this relationship has not been perfect, with a few periods where both stocks and longer-duration bonds both performed poorly.
Since rates began falling in 1981, right up until now, there were two periods where both stocks and bonds declined: ‘83-‘84 and ‘93-‘94. Stocks dropped roughly 14% within the ‘83-‘84 period, and dropped roughly 8% during the ‘93-‘94 period. Other than those periods, stocks have either gone up with bonds, stocks have gone up while bonds have gone down, or stocks have gone down while bonds have increased.
As of the late 1990s, stocks have generally moved in the opposite direction of bonds. See exhibit 1. The bottom graph shows that bond yields have mostly moved with stocks since the late 90s. Because bond prices are inversely related to yield, the green area chart at the bottom of Exhibit 1 means these have had a negative correlation with one another (which is a very good thing for portfolios to have). This is why a portfolio with 50% in stocks, and 50% in bonds, performed much better in the financial crisis (and also during the tech bubble) when compared against a portfolio of 100% stocks.
Exhibit 1: Correlation Between Stocks and Bonds
Higher Short-Term Rates Are Great
There is so much discussion surrounding intermediate to long-term rates and how much pain this can inflict on investors if rates on the long-end of the curve move higher, but no one seems to be noticing that short-term rates have moved higher and will likely continue to do so in the future.
These strategies have all but been forgotten by many investors. Yields on three-month treasury bills are closing in on 2%, and LIBOR rates—which many floating rate strategies are based on—are at 2.2%. See Exhibit 2. The yellow line is three-month T-bills, and the white line is three-month LIBOR. Compared to 0% and 0.25% just a few years ago, 2% is very good.
Exhibit 2: Three-month T-bills and Three-month LIBOR
What may be even better, is that the Federal Reserve will likely raise rates 3-4 more times this year, and so the rates mentioned above should go even higher. Asset managers are estimating some of these ultra-short strategies may be paying close to 2.5% by the end of the year. (As a reference point, the 10-year US Treasury bond only pays 2.85% right now.)
Short Term Rates Can Help Investors Reduce Risk
The beauty of these ultra-short fixed income strategies is that they won’t get hurt much by rates moving higher, since many of these have a duration of less than 0.5.
Yes, the yield is not as high as some longer duration strategies, but there is virtually no interest rate risk and many of these strategies are predominantly investment grade, which means there’s also much less credit risk when compared to things like high-yield bonds.
Imagine for a moment that you could buy a 10-to-20 year treasury bond strategy that pays 2.89% in interest, but carries a duration of almost 11? Or you could buy an ultra-short term bond strategy that pays close to 2%, and has a duration of 0.5. A 1% move on the long end of the yield curve translates into an 11% decline. Add to this a yield of 2.89%, and the total return will likely be around -8%. Alternatively, an investor can stay on the shortest end of the yield curve and a 1% move up in rates may cause a 0.5% decline while they are making 2% in interest. They would have a total return of roughly 1.5%, taking significantly less interest rate risk and still getting a decent yield.
Higher yields on the short end of the yield curve are also good as investors don’t have to take nearly as much risk as they did before. Where investors used to stretch for yield, by either taking on more duration or more credit risk, they are now able to reduce this risk while still having an asset class that has little correlation to stocks.
We believe that bonds will continue to play an important role in most investors’ portfolios.
For more aggressive investors, who have significant weightings to stocks, we continue to believe some duration or interest rate sensitivity is necessary as a high quality hedge. But we believe that shortening the duration further makes sense now as yields continue to rise on the short end of the yield curve.
The other good news is that investors who are almost entirely invested in fixed income need not take on large amounts of duration risk or credit risk. Remember, any environment that allows investors to reduce their risk and still get paid roughly the same is a great environment. For those who are invested primarily on the long end of the yield curve, and don’t need much duration to hedge out some of their exposure to equities, it is not too late to reduce duration and reposition the portfolio to be exposed to less risk of drawdown.