Amidst tight credit spreads, historically low total yields and uncertainty regarding the path of interest rates, investors have questioned the value of fixed income allocations within their portfolios. A fixed income allocation has traditionally provided three key benefits: (1) Diversification, (2) Capital Preservation, and (3) Income. While every economic environment has some unique characteristics, the historical performance of fixed income can still provide guidance for future outcomes.
Since the inception of the Bloomberg Barclays Aggregate Bond Index in 1976, the index has generated positive returns 91% of the time over a rolling 12-month period. Importantly, core bonds have provided capital preservation and liquidity when equity markets are declining. This capital preservation component has persisted in providing protection of capital across a range of yield environments suggesting that low starting yields do not negate the diversification and capital preservation benefits of a core fixed income allocation.
Historical results demonstrate that combining low to negatively correlated assets like equity and fixed income has resulted in better risk-adjusted returns. This correlation relationship has held throughout multiple market cycles and yield environments, but given low starting yields, it is worth re-examining the relationship to see if prior trends will persist. In the US, we saw evidence of this relationship holding in a low-yield environment as the Fed kept rates near zero in the period following the Global Financial Crisis, when the US Aggregate Index recorded a correlation of -0.04 to the S&P 500. This negative correlation continued when the Fed started raising rates in 2015, with a US Agg vs S&P 500 correlation of -0.16. Considering correlations in the context of negative interest rates (using Germany as an example), we see the correlations continuing to hold. German Sovereign bonds produced a correlation of 0.01 to the MSCI Germany equity index over the last five years.
Rising Rates and Return Generation
Rising interest rates also pose a potential hurdle for fixed income investors. Rising rates are not uniformly negative for fixed income returns though. Higher returning, lower duration sectors like high yield, bank loans, emerging market bonds, and hedge funds can do well even as US interest rates rise. These sectors tend to have lower interest rate sensitivity, and in the case of some assets, such as bank loans, benefit from floating rate provisions that will directly adjust coupon payments as rates rise or fall. The trade off however, is increased credit risk, and a tendency toward higher correlation with equities. Historical results indicate that there are several solutions for investors seeking a middle ground between core fixed income and equity that can generate positive returns during rising rate periods.
Balancing Preservation and Return
While evidence suggests that core fixed income can continue to play a diversifying and defensive role in portfolios, inflation creates an additional challenge for investors seeking positive real returns. Inflation in the US has remained contained (around 2%) for the last 25 years and forward-looking estimates (inflation break-evens) suggest this may continue for some time. However, over the next few years, investors remain concerned that a combination of fiscal stimulus, a “zero-bound” Fed, a decline in the COVID-19 virus, and pent-up consumer demand, could result in a near-term overshoot of the Fed’s 2% inflation target. While longer-term return expectations may eventually return to normal, investors will need to seek allocations outside of core fixed income to generate returns in excess of inflation in the near-term.
Despite expectations of lower return and higher volatility, we believe fixed income can continue to provide portfolio protection while offering opportunities for return enhancement. It is important to remember that different parts of the fixed income market react in dissimilar ways to changes in available risk premiums, inflation expectations, and shifts in interest rates.
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