By Doug Fry, CFA®, Portfolio Manager
When reviewing how a fixed-income allocation fits within an investor’s portfolio, it is important to consider an investor’s risk tolerance, performance goals, and income needs. A fixed-income allocation may not be suitable for some investors.
Traditionally, high quality fixed income has played three important roles in an investor’s asset allocation: a steady source of safe income, principal preservation, and risk reduction through diversification. Today, due primarily to massive Government intervention in the credit markets, one of those pillars has been weakened – income. This has caused investors and their advisors to question whether high quality fixed income has lost its place in clients’ portfolios. For many, it has not.
Let’s start with the easy scenario. If you’ve owned your bond portfolio for some time, it may be reasonable to remain invested. The coupons and book yields on those holdings cannot be replaced in today’s low yield, tight spread environment. That existing portfolio likely provided strong cumulative returns in 2019 and 2020 as rates fell and spreads retightened. Chances are you are sitting on solid unrealized capital gains in many of your older holdings.
Why not sell the portfolio and lock in those gains? You can, but where are you going to go with the proceeds if your plan is to reinvest? Cash yields next to nothing and may for some time. High yield bonds are trading near historically low absolute yields offering a sobering risk reward proposition. Equity markets are rich by most measures. Real estate values are stretched. Dollar strength is a headwind for international and emerging markets. There just aren’t any obviously cheap asset classes to redeploy into.
If you are an investor looking to put new money to work in the bond markets, you may come at this decision from a different perspective. Cash flows generated by a high-quality bond portfolio out-yield cash but are still near historically low yield levels. This will likely be the case until rates and/or spreads normalize. But as mentioned above, income is only one of the three reasons to invest in fixed income.
Principal preservation, the second, comes in two flavors. First and foremost is the desire to avoid a negative return. Second is the ability to provide a return at least equal to inflation. At present, cash and short CDs offer the first but fall woefully short on the second. A portfolio of bonds, while not currently keeping up with inflation, does offer positive cash flows. The longer it takes for yields to normalize, the more meaningful that low but positive income becomes.
But what about negative returns, won’t bonds get crushed in a rising rate environment? It is true that fixed income portfolios, especially ones with longer maturity bonds can produce negative returns, even substantial losses. However, that’s generally not the case in the short to intermediate maturity space. In fact, while intermediate bonds may finish 2021 with a slightly negative performance, it will only be the third time in the past 30 years that the Bloomberg Intermediate Government/Credit Index has provided a negative return, the worst being a -1.93% return in 1993. A tough year but not devastating. Additionally, a rising rate environment provides the opportunity to reinvest coupon income and proceeds of maturating bonds at more attractive levels, rebuilding cash flows that collapsed as rates fell. Remember, reinvestment risk works both ways. It hurts as rates fall but creates opportunities when they rise.
Risk reduction through diversification is the third reason to own high quality bonds. We know of few other income producing, liquid sources of returns that are negatively correlated to the equity markets. High yield bonds, floating rate leveraged loans, most structured products - no. They tend to work great when the equity markets are doing well but are unlikely to protect principal when performance turns negative. Cash? You won’t lose money, but you won’t make much either. The problem with cash as a hedge is it has no duration, so no opportunity to generate capital gains when rates fall. This is precisely what happened in 2019-20 as the Federal Reserve drove the Fed Funds rate from nearly 2.5% to 0%. Yields on Money Market Funds and short Certificates of Deposit collapsed, robbing cash investors of income. In contrast, high quality intermediate bonds, again represented by the Bloomberg Intermediate Government/Credit Index, returned 6.80% and 6.43% respectively. That’s negative correlation, that’s diversification.
Clients and their financial advisors are understandably frustrated with the lack of yield available on safe assets. It has led some to question whether they should maintain an allocation to high quality bonds. While income is currently a challenge, that will change as rates and/or spreads normalize. As that happens, the fixed income teams at Madison Investments will take advantage of higher yields, rebuilding the income generated by client portfolios. In the meantime, our high quality short and intermediate maturity strategies stand ready to offer a counterbalance should other risk assets suffer a setback.