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Market View

In a slow-growth, low-rate world, adding high-quality, intermediate-term bonds to a portfolio may be a move of prudent diversification.

In last week’s Market View, we discussed how adding bank loans to a portfolio of investment-grade bonds may better prepare the portfolio for performance in both risk-on and risk-off environments. This time, we’ll take a closer look at the other half of the combination—specifically, how the inclusion of high-credit quality intermediate-term bonds (also known as a “core” strategy) likely can provide essential diversification in a fixed-income portfolio and be a good investment choice in the current environment.

As we pointed out last week, the floating-rate part of the combo has held up well, with bank loans posting positive returns amid a volatile period for financial markets. But concerns are mounting about slowing global growth, fueled by a faltering Chinese economy, and its potential spillover effect on the U.S. economy. Further, with market perceptions increasing that the U.S. Federal Reserve will refrain from raising the fed funds rate in 2015, interest rates seem poised to remain low for some time, despite the Fed’s own, earlier, projections of an interest-rate hike in 2015. In such an uncertain environment, adding high-quality bonds to portfolio may make sense.

Such uncertainty is understandable, especially when it comes to future moves in interest rates. Take a look at Chart 1, which compares consensus interest-rate predictions from a monthly survey by The Wall Street Journal of more than 50 economists, from a variety of financial firms, to actual movements in U.S. Treasury rates. The experts’ predictions have proven to be incorrect nearly two-thirds of the time since the early 1980s. At the start of 2015, the Journal's experts predicted that the 10-year U.S. Treasury note yield would rise by 28 basis points (bps) or more by the end of the year. As of October 16, the yield had actually dropped by more than 29 bps from the beginning of the year. 

 

Chart 1. Tough Call: Economic Experts Continue to Miss on Interest-Rate Forecasts
Six-month interest rate forecast of economists surveyed by The Wall Street Journal versus actual yield movement for indicated periods

Source: The Wall Street Journal Economic Forecasting Survey and the U.S. Department of the Treasury. Data represents the six-month forecast and actual yield for the 10-year U.S. Treasury bond. The Wall Street Journal surveys a group of nearly 50 economists on more than 10 major economic indicators on a monthly basis.
The historical data are for illustrative purposes only, do not represent the performance of any Lord Abbett mutual fund or any particular investment, and are not intended to predict or depict future results. Investors may experience different results. Due to market volatility, the market may not perform in a similar manner 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.
Past performance is no guarantee of future results.  The value of an investment in fixed-income securities will change as interest rates fluctuate and in response to market movements. As interest rates fall, the prices of debt securities tend to rise. As rates rise, prices tend to fall. 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.

 

Of course, there are more than two months still to go in 2015, and circumstances could drive the Treasury yield closer to the experts’ consensus number. But the difference between the October 16 yield and the year-end forecast underscores the difficulty in correctly forecasting interest rates.

What, then, does that mean for fixed-income investors in the current market? Ultimately, a strategy that seeks to boost the performance of a portfolio by calibrating its duration based on expected moves in interest rates may bear fruit from time to time, but consistently predicting interest-rate moves has proven to be extremely difficult. Instead of adding value, such a strategy can often add volatility instead. Wouldn’t it be better to have a diversified portfolio that can respond to different interest rate outcomes? The inclusion of core bonds may help position a portfolio for a slow-growth, low-rate scenario.

Core bonds possess another attribute that investors may find appealing: they historically have held up well when equities have faltered (as Chart 2 shows). It depicts the seven years that stocks (as represented by the S&P 500® Index) have been down since the 1976 inception of the Barclays U.S. Aggregate Bond Index (a broad bond-market benchmark often used as a proxy for the core bond category). In each of those down years for stocks, intermediate-term high-quality bonds provided positive performance, posting an average annual return of 8%. This negative correlation could prove appealing for those who may be concerned about the equity market’s performance in a slow-growth environment.

 

Chart 2. Core Bonds Historically Have Posted Positive Returns in Years When Stocks Have Fallen
Returns for the Barclays U.S. Aggregate Bond Index and the S&P 500 Index 

Source: Barclays and Bloomberg.
The historical data are for illustrative purposes only, do not represent the performance of any Lord Abbett mutual fund or any particular investment, and are not intended to predict or depict future results. Investors may experience different results. Due to market volatility, the market may not perform in a similar manner in the future. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.
Past performance is no guarantee of future results.  The value of an investment in fixed-income securities will change as interest rates fluctuate and in response to market movements. As interest rates fall, the prices of debt securities tend to rise. As rates rise, prices tend to fall. The value of investments in equity securities will fluctuate in response to general economic conditions and to changes in the prospects of particular companies and/or sectors in the economy.

 

The Barclays Aggregate has had only three years of negative returns since its inception, and all the while it has displayed low volatility, with an average standard deviation of 6.9% since inception (as of October 16, 2015), compared with 21.1% for the S&P 500® Index, based on data from Morningstar. (In more recent times, the Barclays Aggregate has displayed even lower volatility, with an average standard deviation of 4.5% over the 10 years through October 16, 2015, while the figure for the S&P 500® was near 25%.) 

The recent struggles of unconstrained bond funds serve as a reminder of the virtues of a disciplined, diversified approach to constructing bond portfolios. Rather than relying on a crystal ball, there are many other ways that portfolio managers could more consistently add value to a fixed-income portfolio. For example, they could emphasize a duration neutral approach involving strategic portfolio rotation among various sectors, and disciplined security selection—identifying securities that are cheap, or expensive, by focusing on their underlying credit fundamentals and risk characteristics.

Given the difficulty in making precise interest-rate calls, it may make sense for investors to include fixed-income categories that historically have posted solid performances when interest rates have moved in either direction. The factors we’ve detailed above suggest that core bonds will continue to play an important role as part of a diversified fixed-income portfolio.

 

MARKET VIEW PDFs


  Market View
  U.S. Market Monitor

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