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Market View

Why consider higher credit-quality intermediate-term bonds? They historically have performed well when equities have declined.

 

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.

 

In the previous Market View, we demonstrated that interest rates are notoriously difficult to forecast, with a representative group of economic experts unable to correctly predict six-month movements in Treasury yields nearly two-thirds of the time. 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.

With that in mind, we think it may be time for investors to take a fresh look at the potential benefits of including “core” bonds  in their portfolios. We have written extensively on how fixed-income categories such as high-yield bonds and bank loans have performed in various interest-rate environments.  In an earlier Market View, for example, we noted that when interest rates have risen, credit-sensitive corporate bonds historically have done well.  But it’s important to note that higher credit-quality intermediate-term bonds—widely considered the core of the typical bond portfolio (hence the name)—have often performed well when interest rates have declined. To illustrate, thus far this year, the Barclays U.S. Aggregate Bond Index (a broad benchmark of investment-grade government and corporate bonds) has returned 3.87% year to date through May 31. Intermediate and longer-term bonds have performed very strongly as well thus far in 2014.

Meanwhile, the credit-sensitive sector also has posted positive returns this year as rates have fallen, as continued optimism on the economy and the attractive coupons that these bonds offer have rewarded investors. As of May 31, 2014, short-term U.S. corporate bonds (as represented by the BofA Merrill Lynch 1-3 Year U.S. Corporate BBB-Rated Index) were up 1.57%, bank loans (as represented by the Credit Suisse Leveraged Loan Index) were up 2.16%, high-yield bonds (as represented by the Credit Suisse High Yield Index) were up 4.73%, and convertible securities (as represented by the BofA Merrill Lynch All Convertibles, All Qualities Index) were up 6.36%. (All index performance data are from Bloomberg and Credit Suisse.) If corporate credit is still outperforming, even as interest rates have fallen, one might conclude that core, intermediate-term bonds may not find the same favor with investors.

While investors are justifiably concerned with relative performance, core bonds possess another attribute that they may find appealing:  they historically have held up well when other assets have faltered, as the accompanying chart shows. It depicts the seven years that stocks (as represented by the S&P 500® Index) have been down since the inception of the Barclays U.S. Aggregate Bond Index in 1976.  In each of those down years for stocks, intermediate-term high-quality bonds provided positive performance, posting an average annual return of 8%. 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 5.49% since inception (as of June 6, 2014), compared with 15.10% for the S&P 500, based on data from Morningstar. (In more recent times, the Barclays Aggregate has displayed even lower volatility, with an average standard deviation of 3.5% over the 10 years through June 6, 2014, while figure for the S&P 500 is still around 15%.) 

But when core bonds have zigged, stocks (and equity-like securities, such as convertible bonds) have zagged. It’s important to note that in the three negative years for the Barclays Aggregate, stocks and equity-like securities were up. Specifically, in the last two negative years for core bonds, 1999 and 2013, the S&P 500 returned 21% and 32%, respectively, according to data from Bloomberg.

We have pointed to the potential benefits of diversifying bond portfolios with exposure to shorter-duration, credit-sensitive instruments in a rising interest-rate environment. The factors we’ve detailed above suggest that core bonds also can play an important role in a fixed-income portfolio. But what if there were a different approach to a core bond strategy, one with historical volatility similar to that of the Barclays Aggregate, but poised to respond to any potential increase in interest rates?  We’ll investigate that in the next Market View.

 

RELATED RESOURCES


  Market View
  U.S. Market Monitor

RELATED FUND
The Fund seeks to deliver current income and the opportunity for capital appreciation by investing primarily in U.S. investment grade corporate, government, and mortgage- and asset-backed securities, with select allocations to high yield and emerging market debt securities.

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