Yield, Stability, Liquidity, and Diversification: Are Fixed Income Allocations Still Up to the Task?

In an era of ultra-low interest rates, we re-examine the purpose and constitution of Core fixed income.

Read time: 7 minutes

High quality fixed income allocations generally start with a simple premise- combine a broad cross-section of publicly traded debt that is investment grade, taking advantage of that diversity to build a portfolio anchor that offers the potential for:

• yield
• stability
• liquidity
• diversification benefits relative to equity holdings

We have been reimagining fixed income allocations for the past several years as the most common approaches—Core and Core Plus—have become a concentrated bet on interest-rate moves while offering frustratingly low yields.  After the market volatility of March 2020, the yield issue has become more acute and new concerns have surfaced.  Few envisioned the economic stress brought about by the pandemic and the liquidity crunch that coincided with its almost immediate onset.  Fewer still imagined the operating cash needs of institutions such as universities and hospitals would be so correlated to market events.   We believe it’s worth asking: How did fixed income allocations hold up during the March turmoil--and is there anything we can do better now that the episode is behind us?

How Did Core Hold Up?

Over the years, core fixed income portfolios have been increasingly dominated by government and agency debt, heightening interest rate risk while offering less and less yield.  Heading into the pandemic crisis, rates represented the vast majority of risk in core fixed income portfolios, as shown in the projected variance model in Figure 1.

Figure 1. Duration Risk Dominates Other Risks in a Key Fixed-Income Benchmark
Sources of variation in returns for the Bloomberg Barclays U.S. Aggregate Bond Index, as of September 30, 2020

Source:  Barclays POINT, Lord Abbett. Variation depicts performance of the Bloomberg Barclays U.S. Aggregate Bond Index versus cash.
Past performance is not a reliable indicator or guarantee of future results. For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment. Indexes are unmanaged, do not reflect the deduction of fees and expenses, and are not available for direct investment. 

This rate exposure did fairly well to stabilize core portfolios as the 10-year U.S. Treasury yield fell from 1.75% to 0.64% during March 2020.  However, spread widening in corporate bonds and negative convexity in mortgage-backed securities limited the impact of the rate move.  Further, some common ways to access generic core fixed income like the iShares Core U.S. Aggregate Bond ETF (AGG; an exchange-traded fund tracking the Bloomberg Barclays U.S. Aggregate Bond Index) traded at substantial discounts to net asset value (NAV) on days when liquidity was needed the most, as shown in Figure 2.

Figure 2. “Agg”-Related Portfolios Struggled to Provide Stability and Liquidity during the March 2020 Market Turmoil

Source:  Bloomberg. Data as of July 31, 2020. The upper panel represents the 10-year U.S. Treasury yield and the spread of the Bloomberg Barclays U.S. Aggregate Credit Index; the lower panel represents the iShares Core U.S. Aggregate Bond ETF (exchange-traded fund) price and net asset value (NAV). OAS=Option-adjusted spread.

Past performance is not a reliable indicator or guarantee of future results. For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment. Indexes are unmanaged, do not reflect the deduction of fees and expenses, and are not available for direct investment.

While rate volatility dampened as rates neared 0%, credit spreads widened, and liquidity deteriorated, the correlation of the aggregate index with equities briefly moved into positive territory.  Long-dated U.S.  Treasuries worked measurably better as diversifiers, maintaining negative correlations with equities for much of the crisis, and provided investors with a much-needed source of liquidity.

Figure 3. The Aggregate Index’s Correlation to Equities Spiked Positive in April 2020

Rolling 30-day correlation of the Bloomberg Barclays U.S. Aggregate Index (AGG) versus the (1) S&P 500 Index (SPY) and (2) the 30-year U.S. Treasury bond, February 14, 2018–July 23, 2020

Source:  Bloomberg and Standard & Poor’s. Data as of 07/31/2020. 

 Past performance is not a reliable indicator or guarantee of future results. For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment. Indexes are unmanaged, do not reflect the deduction of fees and expenses, and are not available for direct investment.

What did we learn from this experience?  There’s no substitute for cash and Treasuries in times of crisis.  Meaningful allocations to those instruments during periods of market stress historically have pulled down portfolio yield and expected return in a dramatic way, however, and need to be offset.

The Outlook for Core Portfolios Benefits Going Forward

Given the market action following the onset of COVID-19, the meager yield from standard core fixed income portfolios like the AGG has grown more problematic, with the Aggregate portfolio yielding less than 1.3% as of July 15, 2020.  Essentially, investors are giving up the first goal of fixed income, yield, for the salutary effects of stability, liquidity and diversification—all of which were only partially realized during the downturn.

Now, with rates near the “zero bound” (i.e., 0%) in the United States, it’s reasonable to ask if these characteristics are still worth paying for.  Experience in other countries provides some support for the continued portfolio benefits of duration risk.  Even as rates dipped into the negative in Europe and Japan, sovereign bonds in those markets continue to exhibit stability, liquidity, and even negative correlation to equity markets, as shown in Figure 4.  Interest rate volatility has been dampened as rates slip below 0%, however, requiring higher hedge ratios, and thus more negative yielding debt is needed to keep a lid on equity volatility.  Essentially the “cost” to the portfolio of including interest rate risk as a hedge continues to increase.

Figure 4. Can Government Bonds Keep a Negative Correlation versus Equities?

Correlation of government bond indexes versus home country equity index (120-day rolling basis¹), June 29, 2015–July 22, 2020 (upper panel); rates volatility of government bonds, December 17, 2010–July 24, 2020 (lower panel)

Source:  Bloomberg and Standard & Poor’s. Data as of 07/24/2020.
¹S&P Japan Government Bond Index vs. MSCI Japan Index; S&P Germany Sovereign Bond Index vs. MSCI Germany Index.
Past performance is not a reliable indicator or guarantee of future results. For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment. Indexes are unmanaged, do not reflect the deduction of fees and expenses, and are not available for direct investment.

A further complication to the use of interest-rate risk as a hedging tool near the zero bound is that the environment in the United States may be different. There is good reason to believe negative rates won’t be tolerated by U.S. policymakers, as U.S. Federal Reserve (Fed) governors have made many statements to this effect, noting the banking system’s importance to the economy and the strategic advantages of the dollar’s unique role as a reserve currency.  If interest rates stay stubbornly positive even in the face of weakening equity markets, the diversification benefits of fixed income portfolios will be harder to achieve.  With the Fed’s self-imposed limitation on rate reduction below zero, fiscal policy and other measures may need to become the primary response to any dip in demand.  Large-scale deficit spending could then cause asymmetric upside risk to inflation, especially when combined with pandemic and trade-related limits to production, threatening the stability characteristic of core fixed income portfolios with large amounts of interest rate risk.

A More Purpose-Built Fixed Income Asset Allocation

Near the zero bound, investors are paying more than ever for rate risk and possibly setting themselves up to realize less utility from that risk.  That’s not to say that rate risk has no place in a portfolio.  We can see the argument for long-term Treasuries as a source of opportunistic or tactical funds if correlations with equities remain negative and liquidity continues.  Additionally, because of their relative stability, short term Treasuries can be useful investments for very risk-averse pools of capital - to meet an organization’s near-term operational needs, for example.    

One way to counter falling yields and increased risk of inflation for Treasuries in a portfolio is to pair these holdings with limited duration credit.  We believe now is one of the most opportune times to add limited duration credit risk to fixed income portfolios that are usually dominated by rate risk.  Though spreads vary widely by sector and quality, in general, credit spreads have not returned to pre-crisis levels and offer relatively high compensation relative to other risk factors.

Figure 5. Recent Yield Advantages in Short Credit
Short duration hypothetical blend yield to worst versus Bloomberg Barclays U.S. Aggregate Bond Index yield, December 31, 2010–September 30, 2020

*Hypothetical Short Duration Blended Allocation (as of 9/30/20, not rebalanced) includes 30% ICE BofA 1-3 Year US Corporate Index, 30% Bloomberg Barclays 1–3.5 Year CMBS Index, 15% ICE BofA 0–3 Year ABS Fixed Rate Index, 15% Bloomberg Barclays 1–3 High Yield Index,10% Bloomberg Barclays 1-3 Year US Govt/Credit Index.
Source: Lord Abbett and Bloomberg. Data as of 09/30/2020. YTW=Yield to worst. Short credit yield from 12/31/2010–9/30/2020.
Past performance is not a reliable indicator or guarantee of future results. For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment. Indexes are unmanaged, do not reflect the deduction of fees and expenses, and are not available for direct investment.

By combining a blend of Lord Abbett Short Duration Income and 30-year Treasuries to target the duration of the Bloomberg Barclays U.S. Aggregate Bond Index, investors could potentially take advantage of the increased yield on offer for short term credit exposures while maintaining the liquidity that U.S. Treasury securities provide.  Figure 6 shows the yield advantage to such a “De-constructed Aggregate” as of September 15, 2020.

Chart 6. Deconstructing Core Fixed Income
Data as of September 30, 2020

Source: Morningstar. Data as of September 30, 2020. * Hypothetical Blend of 83.08% Short Duration Income Fund /16.92% ICE BofA Current 30-Year US Treasury Index. The blend data is gross of fees (blend chosen to match the duration of the Bloomberg Barclays U.S. Aggregate Bond Index).
Past performance is not a reliable indicator or guarantee of future results. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment. Neither diversification nor asset allocation can guarantee a profit or protect against loss in declining markets.

The performance quoted represents past performance, which is no indication of future results. Current performance may be higher or lower than the performance data quoted. Returns shown include the reinvestment of all distributions. Returns shown at net asset value do not reflect the current maximum sales charge, had the sales charge been included, returns would have been lower. The investment return and principal value of an investment will fluctuate so that shares, on any given day or when redeemed, may be worth more or less than the original cost. Therefore, there can be no assurance for future results.
Returns with sales charges reflect a maximum sales charge of 2.25%.

There’s an important distinction between the credit risk in a typical Aggregate or core portfolio and the kind of credit risk in short credit.  Credit spread is compensation for two primary risks, default risk and liquidity risk.  Shorter maturity and higher quality bonds typically have very low default risk—their high credit rating indicates that they have a variety of options available, from business flexibility to financing options, which likely would take years to exhaust.  So most of the risk in these kinds of bonds, both corporate and securitized, is liquidity risk—spreads may widen but the risk to principal is low.  This “pull to par” in the absence of defaults has resulted in short, high quality credit (as represented by the ICE BofA 1-3 Year Corporate Index) returning principal in 96% of all rolling 12-month periods from January 1, 2008 to June 30, 2020, compared to 86% of periods for an aggregate portfolio.¹

The nature of the credit risk in short credit is important because while default risk has been elevated by the economic stress caused by the pandemic, liquidity risk is arguably as benign as it’s ever been because of the actions by the U.S. Federal Reserve (Fed) in response to the pandemic.  On the back of the announcement of Fed facilities to support market liquidity in March, nearly $1 trillion in new issue corporate debt has further buttressed the liquidity position of a large swath of the investment grade market.  In short, companies have rarely had more access to liquidity while investors are being paid well for liquidity risk.

We favor an active, multi-sector approach to short credit portfolios that can complement Treasury allocations. We believe the combination of these two portfolios can form a more “purpose-built” core fixed income portfolio, offering the potential to satisfy liquidity needs for investors while balancing income and stability.

¹ICE BofA index performance data from ICE Data Indices, LLC.

A Note about Risk: The value of investments in fixed-income securities will change as interest rates fluctuate and in response to market movements. Generally, when interest rates rise, the prices of debt securities fall, and when interest rates fall, prices generally rise. High-yield securities, sometimes called junk bonds, carry increased risks of price volatility, illiquidity, and the possibility of default in the timely payment of interest and principal. Bonds may also be subject to other types of risk, such as call, credit, liquidity, interest-rate, and general market risks. Longer-term debt securities are usually more sensitive to interest-rate changes; the longer the maturity of a security, the greater the effect a change in interest rates is likely to have on its price. Lower-rated bonds may be subject to greater risk than higher-rated bonds. No investing strategy can overcome all market volatility or guarantee future results.

Investors should carefully consider the investment objectives, risks, charges, and expenses of the Lord Abbett Funds. This and other important information is contained in the fund’s summary prospectus and/or prospectus. To obtain a prospectus or summary prospectus on any Lord Abbett mutual fund, contact your investment professional, Lord Abbett Distributor LLC at (888) 522-2388 or visit us at lordabbett.com. Read the prospectus carefully before you invest.

Statements concerning financial market trends are based on current market conditions, which will fluctuate. There is no guarantee that markets will perform in a similar manner under similar conditions in the future.

Forecasts and projections are based on current market conditions and are subject to change without notice. Projections should not be considered a guarantee.

This article may contain assumptions that are “forward-looking statements,” which are based on certain assumptions of future events. Actual events are difficult to predict and may differ from those assumed. There can be no assurance that forward-looking statements will materialize or that actual returns or results will not be materially different from those described here.

Glossary

Convexity is a measure of the curvature in the relationship between bond prices and bond yields. Convexity demonstrates how the duration of a bond changes as the interest rate changes. If a bond's duration increases as yields increase, the bond is said to have negative convexity.

Core bond strategies offer a diversified approach to fixed income via broad exposure to the investment-grade area of the bond market. They provide participation in several market segments, most notably U.S. Treasuries, mortgage-backed securities, and investment-grade corporate bonds. Core plus strategies add alternative investments such as high-yield, global, and emerging market debt to a core portfolio of investment-grade bonds.

Correlation is a statistic that measures the degree to which two securities move in relation to each other. A perfect positive correlation means that the correlation coefficient is exactly 1. This implies that as one security moves, either up or down, the other security moves in lockstep, in the same direction. A perfect negative correlation means that two assets move in opposite directions, while a zero correlation implies no relationship at all.

Duration is an approximate measure of a bond's price sensitivity to changes in interest rates. 

Exchange Traded Fund (ETF) is a security that tracks an index, a commodity or a basket of assets like an index fund, but trades like a stock on an exchange. ETFs experience price changes throughout the day as they are bought and sold.

Spread is the percentage difference in current yields of various classes of fixed-income securities versus Treasury bonds or another benchmark bond measure. A bond spread is often expressed as a difference in percentage points or basis points (which equal one-one hundredth of a percentage point). The option-adjusted spread (OAS) is the measurement of the spread of a fixed-income security rate and the risk-free rate of return, which is adjusted to take into account an embedded option. Typically, an analyst uses the Treasury securities yield for the risk-free rate.

Treasuries are debt securities issued by the U.S. government and secured by its full faith and credit. Income from Treasury securities is exempt from state and local taxes.

Yield to maturity (YTM) represents the expected return (expressed as an annualized rate) from the bond’s future cash flows, including coupon payments over the life of the bond and the bond’s principal value received at maturity.1

The yield to worst (YTW) is the lowest potential yield that can be received on a bond without the issuer actually defaulting.

The Bloomberg Barclays U.S. Aggregate Bond Index is an unmanaged index composed of investment-grade securities from the Bloomberg Barclays Government/Corporate Bond Index, Mortgage-Backed Securities Index and the Asset-Backed Securities Index.

Bloomberg Barclays Index Information:

Source: Bloomberg Index Services Limited. BLOOMBERG® is a trademark and service mark of Bloomberg Finance L.P. and its affiliates (collectively “Bloomberg”). BARCLAYS® is a trademark and service mark of Barclays Bank Plc (collectively with its affiliates, “Barclays”), used under license. Bloomberg or Bloomberg’s licensors, including Barclays, own all proprietary rights in the Bloomberg Barclays Indices. Neither Bloomberg nor Barclays approves or endorses this material, or guarantees the accuracy or completeness of any information herein, or makes any warranty, express or implied, as to the results to be obtained therefrom and, to the maximum extent allowed by law, neither shall have any liability or responsibility for injury or damages arising in connection therewith.

The ICE BofA 1-3 Year BBB U.S. Corporate Index is a subset of the ICE BofA 1-3 Year U.S. Corporate Index including all securities with a remaining term to final maturity less than three years and rated ‘BBB1’ through ‘BBB3,’ inclusive.  

ICE BofA Index Information:
Source:  ICE Data Indices, LLC (“ICE”), used with permission. ICE PERMITS USE OF THE ICE BofA INDICES AND RELATED DATA ON AN "AS IS" BASIS, MAKES NO WARRANTIES REGARDING SAME, DOES NOT GUARANTEE THE SUITABILITY, QUALITY, ACCURACY, TIMELINESS, AND/OR COMPLETENESS OF THE ICE BofA INDICES OR ANY DATA INCLUDED IN, RELATED TO, OR DERIVED THEREFROM, ASSUMES NO LIABILITY IN CONNECTION WITH THE USE OF THE FOREGOING, AND DOES NOT SPONSOR, ENDORSE, OR RECOMMEND LORD, ABBETT & CO. LLC., OR ANY OF ITS PRODUCTS OR SERVICES.

The MSCI Germany Index is designed to measure the performance of the large and mid cap segments of the German market. With 62 constituents, the index covers about 85% of the equity universe in Germany. 

The MSCI Japan Index is designed to measure the performance of the large and mid cap segments of the Japanese market. With 320 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in Japan.

The S&P 500^® Index is widely regarded as the standard for measuring large cap U.S. stock market performance and includes a representative sample of leading companies in leading industries.

The S&P Germany Sovereign Bond Index is a comprehensive, market-value-weighted index designed to track the performance of euro-denominated securities publicly issued by Germany for its domestic market.

The S&P Japan Government Bond Index, a subindex of the S&P Japan Bond Index, is designed to track the performance of local-currency denominated government bonds issued by Japanese issuers.

Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

The credit quality of the securities are assigned by a nationally recognized statistical rating organization (NRSRO), such as Standard & Poor's, Moody's, or Fitch, as an indication of an issuer's creditworthiness. Ratings range from 'AAA' (highest) to 'D' (lowest). Bonds rated 'BBB' or above are considered investment grade. Credit ratings 'BB' and below are lower-rated securities (junk bonds). High-yielding, non-investment-grade bonds (junk bonds) involve higher risks than investment-grade bonds. Adverse conditions may affect the issuer's ability to pay interest and principle on these securities.

The information provided is not directed at any investor or category of investors and is provided solely as general information about Lord Abbett’s products and services and to otherwise provide general investment education. None of the information provided should be regarded as a suggestion to engage in or refrain from any investment-related course of action, as neither Lord Abbett nor its affiliates are undertaking to provide impartial investment advice, act as an impartial adviser, or give advice in a fiduciary capacity. If you are an individual retirement investor, contact your financial advisor or other fiduciary about whether any given investment idea, strategy, product, or service may be appropriate for your circumstances.

The opinions in this commentary are as of the date of publication and are subject to change. Additionally, the opinions may not represent the opinions of the firm as a whole. The document is not intended for use as forecast, research, or investment advice concerning any particular investment or the markets in general, and it is not intended to be legal advice or tax advice. This document is prepared based on information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy and completeness of the information.