Stay calm and remember why you own bonds

BlackRock
Karsten Kumpf
Karsten Kumpf
BlackRock Head of Portfolio Management, Multi Asset Strategies Australia
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It’s easy to get sidetracked by the ups and downs of markets especially in volatile times like the present. Now may be a good time to review why you own fixed income in the first place.

Since late February, as the threat and resultant uncertainty surrounding Covid-19 emerged, global equity and bond markets have been historically volatile—on the same level of the 2008-2009 Global Financial Crisis in fact. In March, we saw the fastest bear market correction in the S&P/ASX 200 Index on record.

Interest rates are now hovering around all-time lows, and global governments have enacted massive stimulus plans to try to alleviate some of the economic pain.  From both a human experience and capital markets perspective, these are truly unprecedented times.

For fixed-income investors, this seismic shift in markets can create an immediate urge to act, and quickly. But before acting, it’s best to pause and ask yourself, why do I own fixed income? 

When speaking to our investors, they point to three key reasons:

1. Diversify your Equities


The importance of equity diversification has taken centre stage over the past several weeks as the S&P 500 has entered a bear market. The logic behind diversification is that most investments don’t move together in the same direction at the same time. If an investor holds different types of investments, their gains and losses can potentially offset each other and make the investment experience smoother.

If you take the ASX/S&P 200 to represent the stock market and the Bloomberg Barclays Aggregate Aus. Bond Index for the fixed income market, it’s easy to see that stocks and bonds tend to have an inverse relationship. Their correlation over the past 10 years has been close to zero—meaning stocks and bonds generally go their own ways. And that’s a good thing because it’s less likely that stocks and bonds in a portfolio both go down in price at the same time. Hence, returns would be less volatile over time.

Investors can clearly see diversification in action when equity markets are down and bond investments are there to potentially provide stability to the portfolio.

The below chart shows that investment-grade bonds have typically outperformed when there is a flight to quality, especially during periods of equity market volatility. The largest declines in the S&P/ASX200 Index since the global financial crisis all saw Bloomberg AusBond Composite 0+ Yr Index, as a proxy for Australian investment-grade fixed income, post better returns.

Source: BlackRock, Aladdin ®. Data as at 30 April 2020 in AUD using 76 months of monthly data and a 36-month half-life. Data presented is hypothetical and subject to change. Sample portfolios are for illustrative purposes only, and do not represent a recommendation of any security or asset allocation strategy. This analysis serves as a general summary, which is not exhaustive and should not be construed as investment advice. There is no guarantee that stress testing will eliminate the risk of investing in this fund or strategy.

Why? When stocks fall, money often moves from stocks to bonds—so-called “flight to quality”—pushing bond prices up. Prices tend to go up more for bonds with higher levels of interest rate risk. For this reason, fixed-income investments that have medium to high levels of interest rate risk can potentially provide better diversification to equities than investments with low levels of interest rate risk. This is a very important point, and one that is often missed by investors: If you hold bonds to diversify equity risk, it is preferable to seek interest rate risk.

2. Pursue Income


Income is a bit more intuitive. Most bonds and bond funds pay income on a regular basis, and many investors look for income from their bond portfolio. As a rule of thumb, bonds that carry higher levels of risk pay tend to pay higher levels of income. The two most common forms of risk in fixed income markets are interest rate risk and credit risk, and most bond investments carry one or both of these risks. A quick rundown: Short-term Treasuries have no credit risk and very little interest rate risk, and as a result, they pay a low level of income. A core bond fund with a medium level of credit and interest rate risk pays a higher level of income. A market like high yield bond may only have medium interest rate risk, but its high credit risk could mean high income.

Remember, there is no free lunch here. To get income, investors have to be willing to take on risk. One of the big trends in recent years has been to move away from government bond allocations, or traditional cash solutions such as term deposits, to invest more heavily in global corporate bonds,  high yield bonds and emerging market debt - a practice commonly referred to as “reaching for yield”. 

These options do offer more yield than traditional cash offering, but investors should note that with the higher yield can come an increase in volatility. In the current environment, we believe investors who structure their portfolios appropriately can potentially capture the benefits from investing in higher-yielding sectors that pay a higher income stream.

So, what’s the solution if you need income and equity diversification? Don’t just look at yield and total returns. Try looking for investments that have a history of strong performance, but also have a low correlation to equities.

3. Preserve Capital whilst putting Cash to work


Investors who want to use cash or fixed income to protect the principal of their investments do not want to see prices drop dramatically with the market. Cash and short duration fixed income can be popular choices for this purpose because of their potential for low-level interest rate risk and credit risk. In fact, when thinking about principal protection, it is most important to keep both types of risk in mind. Don’t become preoccupied with one and forget about the other.

Consider this scenario: An investor is worried about interest rate risk but still hopes for some income from investments. Bank loans offer a high yield and stand out from a list of potential low interest rate choices. The problem? Bank loans are similar to high yield bonds in that they carry a high level of credit risk. While they may fare well in a volatile interest rate environment, they would likely fall in price should there be a credit event. Investing in bank loans probably won’t help investors protect principal, and neither would a portfolio that is tilted heavily toward risk.

Shorter dated bonds with both low credit and interest rate risk may be appropriate for this objective. However, it’s important to note that no market security is impervious to temporary periods of market stress or liquidity issues.

Conclusion


Today’s truly unique environment of ultra-low bond yields and sky-high equity market volatility is another good reminder that no single bond investment can achieve diversification, income and principal protection at the same time.  More than ever, it makes sense to understand what you want your fixed-income investments to do and invest accordingly, helping you stick with your long-term investing goals.

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