Client questions present
the best blog post opportunities.
There is no better sample of what is going on in the minds of high net
worth investors.
Recently, a client asked us to comment on the
latest piece from PIMCO’s Bill Gross, which he read in a national
publication. Below is an abridged
version of my response, which outlines various themes, risks, and subsequent
strategies to fixed income moving forward:
- The initial theme of the August Outlook is “there will always be a need for fixed income”. I totally agree. In fact, I would say the demand on the private individual side will increase over time. This is due to the demographic change we will be going through, e.g. an aging population.
- Also, Treasury supply may fall as the budget deficit falls.
- I explained that it would be helpful to look at this client’s own situation. In this case, we are managing the portfolio to withstand a large loss of capital. Of course we can’t protect against any or all loss, but we can build the portfolio to try and avoid the big losses: in effect, win by not losing big. Bonds are still the best way to do that, and the chart below provides historical evidence:
- One could retort that yields have been falling for almost this entire period; thus, bond prices rise. This is true; however, from 1976 to late 1981 bond yields on the 10 year treasury doubled (thus bond prices fall), going from roughly 8% to 16%.
- Further, the max drawdown over a rolling 12 month period was -9.20% for bonds and if you held them for 5 years the low return would be 11%. Thus, even over a 5 year period where interest rates on the 10 Year Treasury doubled, aggregate returns for the asset class were positive.
- Even with the recent spike in interest rates, the largest on record for a similar time frame, most of our bond managers range from down 3% to up 1%. This is hardly the big loss I mentioned earlier.
- I also contend high quality bonds will still offer the greatest hedge against falling risky assets. Thus, the small loss we experienced on the bond side was still worth it given the protection it provides if equity markets reverse course.
- The reason aggregate bond returns can still be positive even as Treasury rates rise (aside from coupon payments) is due to the other major theme of the Gross piece – carry (another way to say yield, but more than a fixed coupon payment). He lists 5, but I will focus on two:
- One way to add carry is through credit spreads, which is the difference between what one type of bond yields and a Treasury bond yields (note: they both have the same duration, or to make it easier, maturity date). In this instance, even when Treasury yields rise if spreads don’t rise (and they typically don’t) the investor still has a positive return. Given the large amount of bond asset classes, there are usually opportunities in one asset class or another to add carry via the credit spread. And at various points some bond asset classes or more advantageous than others.
- A good example is a high yield bond, because the risk of default is substantially higher than that of a Treasury investors receive a higher yield. Assuming the risk of default is low (e.g. when the economy is good), even when Treasury rates rise these bonds can generate a positive return as their interest rates may stay the same or fall (i.e. you collect the interest payment while the value of the bond stays even or rises).
- Another is through maturity extension. Which is to say adding carry by going longer out on the yield curve (e.g. 30 year bond yields more than a 3 month T-Bill).
- Both strategies of adding carry have risk. If the economy picks up and Treasury interest rates rise, then portfolios more geared toward maturity extension will lag. If the economy falters and Treasury rates fall, then portfolios more geared toward credit spread narrowing will lag. Further, there are times when both could move down together, like in May and June and to a lesser extent even now.
- As Gross notes, there are times when it is advantageous to be positive total carry or negative total carry. Further, there are times when certain type of carry is more in vogue than others (e.g. maturity extension when the economy looks shaky). Thus, as opposed to be more passive in our bond portfolios we are being more active.
- Our analysis indicates that skilled active bond traders can find the best places to get carry depending on the environment. But in the event one manager can’t, we are building around a few different ones to smooth out the returns. We are blending these managers based on how much leeway they have in constructing their portfolios, some will favor adding carry through credit spreads and some through maturity extension. The ultimate goal will be a bond portfolio that can stay afloat as interest rise, but provide support to the total portfolio when riskier assets pull back.
The views and opinions expressed herein are those of the
author(s) noted and may or may not represent the views of Capital Analysts,
Inc. or Lincoln Investment. The material
presented is provided for informational purposes only. Nothing contained herein
should be construed as a recommendation to buy or sell any securities. As with
all investments, past performance is no guarantee of future results. No person
or system can predict the market. All investments are subject to risk,
including the risk of principal loss.
