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The State of Fixed Income

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Will Bonds Continue Fulfilling their Dual Role?

An allo­ca­tion to fixed income has tra­di­tion­al­ly been present in all but the most aggres­sive of port­fo­lios, with con­ser­v­a­tive port­fo­lios often being 100% fixed income. Cer­tain­ly, many port­fo­lios have ben­e­fit­ed from their allo­ca­tion to bonds over the last 35 years. But the wise investor should look for­ward, not back­ward, to deter­mine if bonds will be able to deliv­er the dual role they have typ­i­cal­ly served.

But to look for­ward, we must exam­ine the state of bonds today.

 

High Demand for Bonds

Yields have lan­guished at his­toric lows and are slow­ly begin­ning to rise, but the demand for bonds has remained quite high ever since the cred­it cri­sis of 2007-08.

And why wouldn’t the demand be high when the fol­low­ing drove investors to bonds:

  • Investors’ fears of equi­ty mar­kets in the 9+ year bull mar­ket
  • Non-U.S. cen­tral banks main­tained a healthy cush­ion of cur­rent account reserves
  • Open mar­ket oper­a­tions by the Fed­er­al Reserve Bank (i.e., “quan­ti­ta­tive eas­ing”)
  • A very accom­moda­tive mon­e­tary pol­i­cy

As demand for bonds has soared, the yield plum­met­ed. As every stu­dent of finance knows, the yield on bonds is inverse­ly relat­ed to its price. While the Fed even­tu­al­ly start­ed a pol­i­cy of tighter mon­e­tary con­di­tions, the over­hang from a near­ly a decade of loose mon­e­tary pol­i­cy still haunts the mar­ket.

This has left bond investors with an unat­trac­tive set of options:

  1. If rates stay low, bonds are unlike­ly to gen­er­ate enough income to meet their spend­ing needs.
  2. If rates increase, cur­rent bond hold­ings are sus­cep­ti­ble to loss­es in val­ue.

Look­ing at the cur­rent inter­est rate envi­ron­ment and the long-term cred­it cycle, the road ahead for bond investors, as well as, for tra­di­tion­al 60/40 port­fo­lio con­struc­tion is chal­leng­ing indeed.

An Inflection Point for the Bond Market?

Not Much Gas Left in the Tank for Bonds - State fo Fixed Income - Swan Insights

Source: Swan Glob­al Invest­ment, St. Louis Fed­er­al Reserve, Orga­ni­za­tion for Eco­nom­ic Co-oper­a­tion and Devel­op­ment (OECD), Shiller, www.econ.yale.edu/~shiller/data.htm: 10 year U.S. Trea­suries 1926–2018. The 60/40 port­fo­lio refers to 60% Ibbot­son US Large Stock Infla­tion Adjust­ed Total Return and 40% Ibbot­son US IT Gov­ern­ment Infla­tion Adjust­ed Total Return USD.

 

The Income Challenge

His­tor­i­cal­ly, investors aver­aged 6.25% from Trea­sury bonds over the last 40 years. With rates rough­ly a third of that since the Finan­cial Cri­sis, many investors were forced to reach for yield in riski­er assets.

Think about it…at a 6.25% yield, a mil­lion-dol­lar posi­tion in ten-year Trea­suries would pro­duce $62,500 per year, or $625,000 over a decade.  Alter­na­tive­ly, a 2.50% yield would pro­duce only $25,000 per year. That’s rough­ly the def­i­n­i­tion of pover­ty-lev­el income for a fam­i­ly of four[1]….and that’s on a mil­lion-dol­lar port­fo­lio.

So investors should wel­come an increase in rates, right?  With an increase in rates, a decrease in val­ue fol­lows threat­en­ing the cap­i­tal preser­va­tion role of bonds.

 

The Capital Preservation Challenge

Bonds have his­tor­i­cal­ly been able to pro­vide not only cap­i­tal appre­ci­a­tion but also cap­i­tal preser­va­tion. Over the last 35 years (Jul 1983 – Jun 2018) the invest­ment grade bonds of the Bar­clays U.S. Aggre­gate Index have aver­aged an annu­al rate of 7.03%. The graph below shows why.

Decades Long Bull Market in Bonds - State of Fixed Income - Swan Insights

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 2.85% 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. In 2018, the Bar­clays Aggre­gate Bond Index is down -1.62% through June 30th.

 

Duration Risk

The unfor­tu­nate real­i­ty is that the rela­tion­ship between bond val­ues and yields works in reverse: ris­ing inter­est rates decreas­es the val­ues of bonds. Dura­tion mea­sures the sen­si­tiv­i­ty of a bond’s price to changes in inter­est rates. With a cur­rent dura­tion of 5.29 (Morn­ingstar cat­e­go­ry aver­age: Inter­me­di­ate Term Bonds, 6/30/2018), the typ­i­cal bond fund is very sus­cep­ti­ble to cap­i­tal loss­es should inter­est rates rise from their cur­rent 2.85% to the his­tor­i­cal aver­age over the last 40 years of 6.25%.

Those rely­ing on bonds for down­side pro­tec­tion or pro­tec­tion for their often irre­place­able cap­i­tal might be in for a rude shock.

 

Rethinking Fixed Income

Pre­vi­ous­ly bond hold­ers were able to have their cake and eat it too. They received both income when yields were high­er.  Bonds pro­vid­ed not only cap­i­tal preser­va­tion when equi­ty mar­kets sold off, but cap­i­tal appre­ci­a­tion when yields fell. With the cur­rent state of bonds the way it is, investors must choose between yield or pro­tec­tion. They can­not have both.

This forces investors and advi­sors to rethink how they invest for income and man­age mar­ket risk and what it means for their long term finan­cial plans going for­ward. Instead of rely­ing sole­ly on bonds, many may have to look to alter­na­tive funds or strate­gies to ful­fill the two roles bonds have done in the past.

 

 

About the Author:

Marc Odo, Marc Odo, CFA®, CAIA®, CIPM®, CFP®, Director of Investment Solutions - Swan Global InvestmentsMarc Odo, CFA®, CAIA®, CIPM®, CFP®, Client Port­fo­lio Man­ag­er, 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.

 

 

 

 

 

Important Notes & Disclosures:

[1] https://www.uscis.gov/sites/default/files/files/form/i-864p.pdf

Swan offers and man­ages the pro­pri­etary Defined Risk Strat­e­gy (“DRS”) for its clients includ­ing indi­vid­u­als, insti­tu­tions and oth­er invest­ment advi­sor firms. Swan’s DRS per­for­mance results here­in are of the DRS Select Com­pos­ite which includes all non-qual­i­fied accounts. Addi­tion­al infor­ma­tion regard­ing Swan’s com­pos­ite poli­cies and pro­ce­dures for cal­cu­lat­ing and report­ing per­for­mance returns is avail­able upon request. All Swan per­for­mance results have been com­piled sole­ly by Swan Glob­al Invest­ments and are unau­dit­ed. Oth­er per­for­mance return fig­ures indi­cat­ed in this mate­r­i­al are derived from what Swan believes to be reli­able sources (i.e., S&P 500 index, oth­er index­es and bench­marks), but Swan does not guar­an­tee its reli­a­bil­i­ty. This analy­sis is not a guar­an­tee or indi­ca­tion of future per­for­mance. Invest­ments in for­eign secu­ri­ties involve addi­tion­al risks includ­ing cur­ren­cy risk. Ref­er­ences to the S&P 500 and oth­er indices and bench­marks are for infor­ma­tion­al and gen­er­al com­par­a­tive pur­pos­es only. Index­es are unman­aged and have no fees or expens­es. An invest­ment can­not be made direct­ly in an index. The adviser’s depen­dence on its DRS process and judg­ments about the attrac­tive­ness, val­ue and poten­tial appre­ci­a­tion of par­tic­u­lar invest­ments, ETFs and options in which Swan invests or writes may prove to be incor­rect and may not pro­duce the desired results. Swan Glob­al Invest­ments, LLC, Swan Cap­i­tal Man­age­ment, LLC, Swan Glob­al Man­age­ment, LLC and Swan Wealth Man­age­ment, LLC are affil­i­at­ed enti­ties.   Fur­ther infor­ma­tion is avail­able upon request by con­tact­ing the com­pa­ny direct­ly at 970–382-8901 or www.swanglobalinvestments.com328-SGI-080818

By |2018-10-04T12:00:29+00:00August 13th, 2018|Blog|Comments Off on The State of Fixed Income