Can Fixed Income Continue to Provide Both Income and Capital Preservation?
Fixed income investments historically served a dual role in a portfolio, to provide both fixed income and capital preservation.
Can that dual role be maintained as fixed income investments face both near term and long term challenges?
An allocation to fixed income has traditionally been present in all but the most aggressive of portfolios. Conservative portfolios are often 100% fixed income. Certainly many portfolios have benefited from their allocation to bonds over the last 35 years. But the wise investor should look forwards, not backwards.
When considering conditions today and for the foreseeable future, the ability for bonds and fixed income investments to deliver against the dual role they typically serve in a portfolio is in question. Yields are at historic lows and demand for bonds have remained quite high ever since the credit crisis of 2007-08 for a variety of reasons:
- Investors’ fears of equity markets;
- non-U.S. central banks maintaining a healthy cushion of current account reserves;
- open market operations by the Federal Reserve Bank (i.e., “quantitative easing”);
- and a very accommodative monetary policy.
As every student of finance knows, the yield on bonds is inversely related to its price. As demand for bonds has soared, the yield has plummeted. So let’s look at the challenges for bond investments today and going forward.
The Income Challenge
First let’s consider the challenge to the income producing role of bond allocations in a portfolio. The yield curve shown below highlights this situation. An investor purchasing U.S. Treasuries on June 18th, 2015 is signaling a willingness to be compensated at an annual rate of 2.35% over the next ten years, and 3.14% over the next thirty. Yields this low are unlikely to even cover the rate of inflation, leaving Treasury investors today with a negative real return.
Source: Data from www.treasury.gov
The Capital Preservation Challenge
What about the other role fixed income plays in a portfolio, that of capital preservation? Certainly over the last three decades bonds have filled this role admirably, offering not only capital preservation but capital appreciation. Over the last 35 years (Jan 80 – Dec 14) the investment grade bonds of the Barclays U.S. Aggregate Index have averaged an annual rate of 8.16%.
Source: Zephyr StyleADVISOR, www.research.stlouisfed.org
The graph above illustrates why. As inflation was tamed and interest rates descended from an eye-popping 15.8% in 1981, the value of high-yielding investment-grade bonds increased dramatically. Today, with yields at 2.35% there is little upside remaining. In fact, many would argue there is much more downside to bonds than upside.
With such a long, steady fixed income bull market, it is easy to forget bonds can lose money, especially when interest rates change. Duration measures the sensitivity of a bond’s price to changes in interest rates. With a current duration of 4.85 (Morningstar category average: Investment Grade Bonds, 6/18/2015), the typical bond fund is very susceptible to capital losses should interest rates rise from their current low of 2.35% to the historical average over the last 30 years of 5.44%.
Those relying on bonds for downside protection, or protection for their often irreplaceable capital, might be in for a rude shock.
Such drawdowns are by no means unprecedented. A study by Dimson, Marsh and Staunton examined the drawdown in real terms of US and UK bonds and equities over an 80 year period. Post-war bond investors experienced a much greater loss of wealth than equity investors.
OK… So What Can We Do?
- What can an investor do if fixed income can no longer fill the role of capital preservation in a portfolio?
- If an investor is protecting a 60% position in equities with a 40% allocation to bonds, what would happen if equities and bonds happen to fall in value simultaneously?
Swan’s Defined Risk Strategy (DRS) was designed to address market risk directly. Diversification strategies only work if the historic relationships between investments continue in the future. By protecting its equity holdings with long-term put options, Swan DRS seeks capital preservation via hedging, rather than relying on bonds that can undergo very long periods of loss and drawdown. We believe a hedged equity approach may be a better downside protection option given current market conditions.
[author] [author_image timthumb=‘on’]http://swanglobalinvestments.com/wp-content/uploads/2015/03/marcodo.jpg[/author_image] [author_info]Marc Odo, CFA®, CAIA®, CIPM®, CFP®, Director of Investment Solutions, is responsible for helping clients and prospects gain a detailed understanding of Swan’s Defined Risk Strategy, including how it fits into an overall investment strategy. Formerly Marc was the Director of Research for 11 years at Zephyr Associates.[/author_info] [/author]
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