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Market View

The move to higher rates has led many investors to review their core fixed-income allocations.  

 

In Brief

  • Despite the expectations for higher rates, high-quality bonds may play a valuable role in investors’ portfolios.
  • An active approach, with select exposure to high-yield credit, may present opportunities for better risk-adjusted returns.
  • Over the long term, a blend of credit-sensitive bonds with interest-rate sensitive bonds has led to higher returns without higher volatility.

 

As was widely anticipated, the U.S. Federal Reserve (the Fed) raised its target overnight interest rate (the fed funds rate) by 0.25% on March 15. After keeping the fed funds rate near zero for nearly seven years, this marked the third interest-rate hike by the Fed since December 2015. Market consensus calls for a continuation of Fed hikes, as economic data suggest that the U.S. economy is strong enough to withstand further moves toward policy normalization.

The move toward higher rates has led many investors to review their fixed-income allocations in order to assess whether they are properly positioned for a potential environment of rising interest rates. We have covered this topic several times in recent years, highlighting those asset classes that historically have tended to do well during periods of rising rates, namely high-yield bonds, floating-rate bank loans, short-duration corporate bonds as well as equity-related securities.

 A traditional core-bond strategy, one that typically tracks the Bloomberg Barclays U.S. Aggregate Bond Index (“Aggregate Index”), would seem to face headwinds during a period of rising interest rates. The index is comprised of 100% investment-grade securities, and has approximately two-thirds allocated to U.S. government and government-related securities, which tend to be most affected by rising yields on U.S. Treasuries.

Does that mean that investors should abandon their core bond allocation? Not necessarily. In addition to providing a source of income, high-quality bonds may play an important role in a portfolio:

  • Portfolio diversification—High-quality bonds historically have had negative correlation with U.S. equity returns. In fact, in each of the seven calendar years that the S&P 500® Index has had negative returns in the past 40 years, the Aggregate Index has been positive, with an average annual return of 8%. This can provide balance to a portfolio during difficult equity periods.
  • Reduced volatility—Over the past 10 years, the Aggregate Index has had a standard deviation of 3.3%, or only 20% of the volatility of the S&P 500.

But given the risks of the Aggregate Index, a passive approach of simply following the index may not be ideal in today’s environment.  As illustrated in Chart 1, the characteristics of the index have changed over time. The duration of the index has extended by over 30% from where it stood a decade ago, while the average yield in the index has declined by 50%.  The index currently has an effective duration of 6.0 years, with an average yield of 2.7%, leaving little cushion to generate positive returns in the face of rising rates.

 

Chart 1. A Passive Approach to the Aggregate Index May Not Be Prudent in a Rising-Rate Environment
Bloomberg Barclays U.S. Aggregate Bond Index duration and average yield for 2/2005–2/2017

Source: Bloomberg and Barclays. 
Past performance is no guarantee of future results. Due to market volatility, the asset classes depicted in this chart may not perform in a similar manner in the future. 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 or expenses and expenses, and are not available for direct investment.

 

It is important for those who may choose a passive approach to understand the risk exposures in the index. For those investors who are concerned about this combination of high interest-rate risk exposure with little yield, the question is, “What can they do?” Here are a few alternate approaches to consider:

Add a little credit—Some investors want to avoid risk in their core bond holding, and so may prefer to stay with a 100% investment-grade mandate such as the Aggregate Index. However, securities with a lower credit rating, such as high-yield bonds, historically have provided opportunities for increased income, higher total returns, and stronger performance during periods of rising rates. In addition, since high-yield bonds historically have had a negative correlation to U.S. government bonds, adding high yield to an investment-grade portfolio potentially can reduce overall portfolio volatility.

Consider, for example, the Bloomberg Barclays U.S. Universal Index (“Universal Index”), which has a similar composition to the Aggregate Index, but includes a modest allocation to high-yield corporates as well as a higher allocation to sovereign debt relative to the Aggregate Index. As of February 28, 2017, the Universal Index had approximately 8.5% allocated to below investment-grade securities. This exposure to credit has led to higher returns over time. However, some may be surprised to learn that this higher return has not come with higher volatility. In fact, over the long term, the Universal Index has generated higher returns with slightly lower volatility, and, therefore, more attractive risk-adjusted returns. (See Chart 2.)

Introduce flexibility—Taxable fixed income encompasses a large universe, providing a wide opportunity set that allows active managers multiple levers to attempt to enhance returns, while managing risk. They can adapt to the market environment by adjusting a portfolio’s maturity and term structure, credit quality, sector, and industry exposure. Rather than matching the benchmark weight, an active manager can overweight lower-rated investment-grade and high-yield corporate bonds, for example, that may benefit from an improving economy.

In addition, other sectors such as asset-backed securities (ABS) and commercial mortgage-backed securities (CMBS) present high-quality asset classes that have offered attractive yield over U.S. Treasuries, and may present relative-value opportunities compared to corporate bonds. However, these sectors have a minimal allocation in the Aggregate Index. (As of February 28, 2107, ABS and CMBS represented 0.4% and 1.7%, respectively, of the index.) An actively managed approach can take advantage of unique opportunities in such sectors when a passive index approach cannot.

Expand the fixed-income universe—Since different bond sectors are driven by different factors, building a diversified portfolio of multiple strategies can help enhance return, while reducing interest-rate sensitivity, without adding additional volatility. 

Those fixed-income sectors that historically have fared well during periods of rising rates offer several attractive benefits. For example, short-term corporates have low duration, leading to limited price movements in the face of rising rates, or during periods of credit spread widening. High-yield corporates offer a source of high income and potential total return. Although high-yield corporates may have an intermediate-stated duration, they historically have had a negative correlation with U.S. Treasury securities, and so have less sensitivity to rising Treasury yields. Floating-rate loans also have negative correlation with U.S. Treasuries. Since loans have coupons that adjust with short-term rates, they can benefit from a rise in the London interbank offer rate (LIBOR; which typically moves with the fed funds rate). In addition, since loans do not have the duration exposure of typical fixed-rate bonds, prices are not affected by moves in long-term rates.

 

Table 1: Credit Sectors Provide Opportunity for Increased Income, with Less Rate Sensitivity

Source: Bloomberg, Bank of America/Merrill Lynch, and Credit Suisse.
Past performance is no guarantee of future results.
 Due to market volatility, the asset classes depicted in this chart may not perform in a similar manner in the future. 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 or expenses and expenses, and are not available for direct investment.

 

Some investors may be hesitant about adding exposure to these sectors since they present more credit risk than the largely government-related Aggregate Index. However, Chart 2 illustrates that adding exposure to these sectors historically has increased returns without adding volatility.

 

Chart 2: A Diversified Portfolio of Multiple Strategies May Enhance Returns While Lowering Volatility
25 years (02/28/1992-02/28/2017)

Source: Zephyr.
Aggregate represented by the Bloomberg Barclays U.S. Aggregate Index. Credit Blend consists of an equal blend of the Bloomberg Barclays U.S. Corporate High Yield Index, the Bloomberg Barclays U.S. Corporate Index, the Credit Suisse Leveraged Loan Index and the BofA Merrill Lynch 1-3 Year U.S. Corporate Index.
Past performance is no guarantee of future results. Due to market volatility, the asset classes depicted in this chart may not perform in a similar manner in the future. 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 or expenses and expenses, and are not available for direct investment. Diversification does not guarantee a profit or protect against loss in declining markets.

 

For example, in Chart 2, we created a blended portfolio of 60% Barclays Aggregate with a 40% allocation to four U.S. credit sectors: high-yield corporate bonds, investment-grade corporate bonds, leveraged loans, and short-term corporate debt. Over the past 25 years, this blended index generated higher returns with less volatility than the Aggregate Index. If we shifted even more into these credit sectors, and used a blend of 40% Barclays Aggregate and 60% allocated across these sectors, the result would be even higher returns, still with less volatility than the Aggregate Index alone.1 Once again, some may be surprised at these results, but this illustrates the diversification benefits of combining asset classes that are not perfectly correlated.

To be sure, there are certain environments when credit will be out of favor, and the longer-duration government-related securities that make up the bulk of the Aggregate Index will outperform. In a similar fashion, lower-duration and lower-quality credit-sensitive securities will tend to outperform during periods of an improving economy accompanied by rising rates.

History has demonstrated that the direction of interest rates has been notoriously difficult to predict with any accuracy or even consistency. Rather than making large bets on the timing of interest-rate changes, it may be more prudent to have allocations to multiple sectors of the bond market. The diversification benefits of blending interest rate-sensitive sectors with credit-sensitive sectors may lead to more attractive risk-adjusted returns.

 

1These allocations are simply for illustrative purposes and are not meant to be a recommended asset allocation.

 

This commentary 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.

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. Bonds may also be subject to other types of risk, such as call, credit, liquidity, interest-rate, and general market risks. 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. Moreover, the specific collateral used to secure a loan may decline in value or become illiquid, which would adversely affect the loan’s value. 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. Statements concerning financial market trends are based on current market conditions, which will fluctuate. Diversification does not guarantee a profit or protect against loss in declining markets.

The BofA Merrill Lynch 1-3 Year U.S. Corporate Index is comprised of U.S. dollar-denominated investment-grade corporate debt securities publicly issued in the U.S. domestic market with between one and three years remaining to final maturity.

The Bloomberg 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. Total return comprises price appreciation/depreciation and income as a percentage of the original investment.

The Bloomberg Barclays U.S. Universal Index covers U.S. dollar-denominated taxable bonds that are rated investment grade or high yield.

The Bloomberg Barclays U.S. Corporate High Yield Index measures the U.S. dollar-denominated, high-yield, fixed-rate corporate bond market.

The Bloomberg Barclays U.S. Corporate Index measures the investment-grade, fixed-rate, taxable corporate bond market. It includes U.S. dollar-denominated securities publicly issued by U.S. and non-U.S. industrial, utility, and financial issuers.

The Credit Suisse Leveraged Loan Index is designed to mirror the investable universe of the U.S. dollar-denominated leveraged loan market.

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.

A bond yield is the amount of return an investor will realize on a bond.

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

LIBOR is an interest rate at which banks can borrow funds, in marketable size, from other banks in the London interbank market. The LIBOR is fixed on a daily basis by the British Bankers' Association. The LIBOR is derived from a filtered average of the world's most creditworthy banks' interbank deposit rates for larger loans with maturities between overnight and one full year.

Negative correlation is a relationship between two variables in which one variable increases as the other decreases, and vice versa. In statistics, a perfect negative correlation is represented by the value -1.00, while a 0.00 indicates no correlation, and a +1.00 indicates a perfect positive correlation.

Standard deviation is a measure of a measure of volatility. It indicates the variability of an investment's returns.

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. Although U.S. government securities are guaranteed as to payments of interest and principal, their market prices are not guaranteed and will fluctuate in response to market movements.

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. High yielding, non-investment-grade bonds involve higher risks than investment-grade bonds. Adverse conditions may affect the issuer’s ability to pay interest and principal on these securities.

The opinions in Market View are as of the date of publication, are subject to change based on subsequent developments, and may not reflect the views of the firm as a whole. The material is not intended to be relied upon as a forecast, research, or investment advice, is not a recommendation or offer to buy or sell any securities or to adopt any investment strategy, and is not intended to predict or depict the performance of any investment. Readers should not assume that investments in companies, securities, sectors, and/or markets described were or will be profitable. Investing involves risk, including possible loss of principal. This document is prepared based on the information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy and completeness of the information. Investors should consult with a financial advisor prior to making an investment decision.

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