Podcast: Addressing a Core Issue for Fixed-Income Investors
VOICEOVER: Welcome back to The Investment Conversation. I’m Tony Fisher.
VO: Investors in core bonds might not be aware of some trends that are working against the strategy right now, including low yields coupled with rising duration. And that raises some fundamental questions about the risk these portfolios face in the current market. My colleague Will Andrews sat down with Lord Abbett Managing Director and Investment Strategist Joseph Graham to explore the topic.
William Andrews: Joe it's good to have you back.
Joseph Graham: Thank you, Will.
Andrews: In our podcast last March, you talked about the potential portfolio uses of short credit strategies and cash management applications. Now we're going to switch gears and talk about something different, something that affects a broad range of investors and that's the potential challenges to core bond portfolios that we see today.
Graham: There's no immediate problem with core portfolios, the issue is the rate exposure that that core portfolios introduce into a portfolio. Now, rates have been a great addition to portfolios over the years.But it's very possible they won't be in the future, so I think it's worth exploring how investors might want to balance that risk. Now, the first thing to understand is core portfolios really are rate risk. Core plus is a little bit different, you know that there is some credit in core plus portfolios. The rate risk that's within core has crept up over the years to now over six and a half years of duration risk compared to something like a 1.4% yield and, you know, your own core portfolio may vary, but that's where the Barclays aggregate [i.e., Bloomberg U.S. Aggregate Bond Index] is. That's a pretty bad trade-off, to be honest, you know six and a half years of duration to 1.4% yield.
In fact, if you run a risk model more than all of the variation in returns in a typical aggregate-type portfolio is due to rate risk, so the problem we have with rate risk isn't it in itself it's that it's a pretty concentrated bet in core portfolios.
Andrews: Let’s talk a little bit more about the disadvantages of taking on you know too much rate risk -- what's the consideration here?
Graham: Right, that's kind of the second problem, the one is the concentration, the other is the rate risk itself how's that priced. When you look historically, we're at pretty bad levels and in terms of rate risk pricing and that can be a complex topic, but there's two sort of easy ways to look at it, when we're looking at how rates are priced. One is what real rates look like, so what that is is you just take out inflation expectations from nominal rates.
And right now, if you do that, you have a very negative real rate pretty much anywhere inside of 20 years and that's because inflation expectations are high. Mid to high twos (2%) whether you're looking at the five year or 10-year inflation swap and rates are obviously well below that. Now that can happen over periods when the Fed wants to be very stimulative like now. But it's pretty hard to keep that posture for a long time and we've seen that in other periods, so one of the two has to budge either inflation has to fall or rates have to rise.
And that second part, rates having to rise to adjust for inflation, that's a big risk.
The second way you can look at it is to look at short-term rate expectations and kind of figure out where long term rates should be based on those expectations just by averaging up short term rates over time. If you do that, which you find is right now, if your average up short-term rate expectations it's higher than where long-term rates are so what that means is there's this negative term premium. So normally you get paid something to lock up your money. Right now you're actually paying to lock up your money, so the term premium is negative, and that that's a pretty unusual circumstance.
Andrews: So, in a nutshell, then investors are actually paying to take on rate risk. That doesn't seem to be a very good deal--why would they do that?
Graham: Right and that's the thing. Well, there are a bunch of demand drivers. One is just you know the Fed is out there, buying bonds. LDI on the institutional side is very popular--that's liability-driven investing, where they kind of have to buy bonds to match up liabilities. And then foreign investors are another big source of flows in bonds. But the other thing is, rates have been really good diversifiers in aand portfolio so it's actually rational, you know, to accept even a negative expected return if it diversifies other things in your portfolio and allows you to take risk elsewhere.
You know, both rates and credit have been your friend over time--rates are really your friend when things are down, and you need it so when everything else in your portfolio is going badly rates tend to do well. At least that has been the case. So this negative correlation between rates and especially equities--that's the really important one. That negative correlation, that's been the state of capital markets, the last 20 years, the question is, though, will it be going forward, you know, when you look at history when correlations go positive between rates and equities it's usually due to inflation concerns. So just at the time that bonds are kind of taking it on the chin because they have to price in inflation risk, they typically become less valuable in portfolios because of this rising correlation. So you get a hit from two fronts and that's one of the reasons why we think rate risk is so risky right now, when obviously inflation is a potential problem.
Andrews: So if we do get to have inflation sort of waiting in the wings and we certainly seen a lot of reports on that, this seems to be a little bit of a challenge for investors, who are looking to kind of negotiate all this. How might they respond to these challenges? What approaches can they take?
Graham: So the first thing you can do is just shorten duration. You actually don't take much of a hit in terms of yield and expected return to do that, but you still take some … I mean, if you shorten up to a [U.S.] Treasury portfolio of one year in duration you're not going to make much interest, obviously. And the other thing you can do to keep your yield and even increase it is add in credit risk.
Andrews: So, and that that sounds like a pretty good plan, but you know if anybody looks at the credit spreads right now, they seem rather tight --what's your response to that?
Graham: That's that that's right there at all-time tights [as of September 16, 2021], but I think you do need to look through and look at the components of credit risk to see if these all-time types are justified and, in our opinion, they are. So the big components of credit risk are default and liquidity, or something you could just lump under price risk. With defaults we have really this amazing story building on where defaults of have been--they've been very low this year. And then you look at the distressed ratio in high yield, which is where defaults come from distressed high yield securities. And that's at a low about 2% so normally about 30 to 40% of distressed securities end up in defaults in any given year.
So you can kind of do the math there and realize that defaults are going to be very low, this year, probably well below 1%. But more than just this year, there's a secular trend in the US, if you look at rolling five year defaults each peak that's come with a recession has been shorter and shallower. And we think that's due to the popularity of you know, these interventionist policies like look at what the Federal Reserve did in March … March of 2020 I have to be clear, but there's simply isn't the appetite anymore for the kind of creative destruction process that we normally associate with old school American capitalism. I'm not sure what that means for competitiveness, you know going forward but it's great for credit, it means we're probably going to have lower defaults in the future similar to Japan and Europe, and in those sorts of areas that have had more interventionalist policies.
The second component of credit risk is liquidity and here again there's really excellent short term dynamics, a lot of liquidity looking for a home in the short-term market. But, more importantly, long term dynamics, more importantly, for pricing this idea of like a left tail or black swan event of a liquidity seizure like kind of what we had happened in March of 2020--we think that's been significantly diminished the idea that that will happen again, because of the actions taken by the Fed and in March of 2020. So those Fed programs, the fiscal spending the coordination of it all, how quickly it was all rolled out it worked really well to stabilize markets.
So the chances, I think, of those kinds of programs happening again very, very high meaning liquidity risks should be smaller and spread should be tighter in the future, both from a liquidity perspective and from a default perspective.
Andrews: So in in sort of rolling all that up, it seems to project a pretty positive outlook for credit. So with That said, how can investors kind of really you know use credit or incorporate credit as a compliment to their core holdings and potentially along the way you know sort of mitigate rate risk that they've seen.
Graham: Adding credit risk, you know you can do it in a number of different ways, you can do it with short-term high-quality credit like a short duration strategy which, which of course we offer, or longer-term, more levered credits more down in the capital structure, like our multi sector strategy or high yield which have both done a great job of complimenting rate risk that's so prevalent in core portfolios. It brought down the overall risk when you use the two in conjunction historically because credit and rate risk, they usually move in opposite ways.
And not always--there are times like the taper tantrum in 2013 where rates are going up and spreads widen, but generally those events are pretty brief and by the way, this time around, I think the Fed’s handling of an eventual taper seems to be much more communicated to the market, much more careful and so we don't fear the same thing this time around.
Andrews: So Joe, let's let's look at some key numbers here. What does the risk-return picture look like for credit versus core?
Graham: Yeah, core right now it's kind of mentioned in the if you look at just an aggregate portfolio is around one and a half 1.4 to 1.5%--and we're recording this on September 16. Yield the worst on a short duration more credit-oriented portfolio, it's around the same or a little bit higher about 1.6% range, but this is for two years of duration versus six and a half years, so we think that's a much better tradeoff.
If you're looking for more yield, higher expected total return, our multi sector portfolio has a yield to worst in the three and a half percent range.
And by the way, not everything in there is yielding so expected returns are a bit higher and that's with less duration risk than the Agg [Bloomberg U.S. Aggregate Bond Index] it's a little under six years versus about six and a half for the Agg. So we'd recommend incorporating those two ideas into core portfolios for most clients.
Andrews: So thanks Joe, and one last big-picture question -- For long term investors, what's the proper way to think about the roles of core and credit within a fixed income portfolio?
Graham: Yeah, I spent a lot of this podcast talking about the advantages of credit right now, but I do want to emphasize that the complementary nature of core portfolios and rate risk and credit risk. Even if correlation spikes the rate-sensitive instruments that are common in core fixed income portfolios, they tend to do very well in a crisis we've seen that time and time again, they give you a lot of flexibility and portfolios. So that's their role in an allocation.
The other roles for core fixed income--price stability if rates rise, diversification from equities--those are things that are more in question, and I think that's where adding credit can diversify or help diversify those core exposures add yield and protect you from rising rates.
Andrews: So, Joe this has been a really a terrific discussion we've had some great perspective on this important topic. I just want to thank you once again for being with us today.
Graham: Thank you, Will.
Andrews: As a reminder, or listeners can access White Papers and investment commentary from Joe Graham and other Lord Abbett thought leaders by visiting our website, lordabbett.com, or by contacting their Lord Abbett representative.
Andrews: Be sure to listen to another in our recent series of investment Conversation podcasts: Giulio Martini talking about the Humpty Dumpty economy and what it means for investors.
VOICEOVER: Subscribe and rate us on Apple Podcasts, Spotify, or your favorite streaming app of choice. Thank you for listening.
LDI refers to liability-driven investing, an investment strategy based on the cash flows needed to fund future liabilities.
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.
A black swan is an unpredictable event that is beyond what is normally expected of a situation and has potentially severe consequences.
Core bond portfolios invest primarily in investment-grade U.S. fixed-income issues including government, corporate, and securitized debt. Core plus is an investment management style that permits managers to add instruments with greater risk and greater potential return to a core bond strategy.
Correlation is a statistical measure that describes the strength of relationship between two variables. It can vary from 1.0 to -1.0.
Duration is a measure of the sensitivity of the price (the value of principal) of a fixed-income investment to a change in interest rates.
Spread is the percentage difference in current yields of various classes of fixed-income securities versus Treasury bonds or another benchmark bond measure.
The yield curve is a graphical representation of the interest rates on debt for a range of maturities.
The yield to worst is the lowest potential yield that can be received on a bond without the issuer actually defaulting.
The Bloomberg U.S. Aggregate Bond Index, or “Agg,” formerly known as the Barclays U.S. Aggregate Bond Index, represents securities that are SEC-registered, taxable, and dollar denominated. The index covers the U.S. investment-grade, fixed-rate bond market, with index components for government and corporate securities, mortgage pass-through securities, and asset-backed securities.
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The credit quality of the securities in a portfolio is 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 principal on these securities.
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