While advisers are increasingly moving away from traditional simple fixed-income portfolios for their clients, many are still using basic tools to analyze bonds, despite the increasing complexity of the fixed-income market.
The pervasive fear of rising rates leads many analysts to focus on duration, or interest rate sensitivity. However, changes in the yield of many securities in the global fixed-income universe are not necessarily well correlated to changes in benchmark-type bonds like U.S. Treasuries. This confusion results in many advisers not appreciating the true risk of their clients' portfolios.
In speaking with financial advisers and investors since the end of the financial crisis, I've learned that many of them have been reconsidering the role of fixed income in their portfolios. On one hand, the need for diversification against equity market downturns is an important rationale for a continued position in high-quality bonds like U.S. Treasuries. However, many market participants have cut their allocation to these types of securities given the extremely low real (after inflation) rates available. Worldwide, the situation is even more challenging, with many European government bonds trading at negative nominal yields, and those negative returns don't even consider the corrosive effect of inflation. The current environment is in contrast to the 4% real returns that were available from the 10-year U.S. Treasury as recently as the late 1990s.
Instead of focusing on typical high-quality fixed income with its very low potential returns, many advisers have increased their clients' allocation to asset classes such as high-yield bonds, bank loans, non-U.S. dollar bonds and emerging-market bonds. At the same time, the market sizes for these kinds of bonds have increased significantly — the high-yield corporate bond market has doubled in size since 2007. While providing additional yield and the promise of a higher return, these securities are also higher risk, have lower liquidity, and in general are more volatile than their high-quality cousins. At this point, given the global financial crisis in 2008 and the European crisis in 2011, most advisers are reasonably attuned to the potential for drawdowns in these kinds of portfolios. However, several challenges remain for investors to truly understand the risks of these alternatives to a traditional fixed-income allocation.
MEASURING RISK
One key issue is the increasing use of derivatives in portfolios that are even more plain vanilla, which can make deciphering a portfolio's holdings more challenging. More important, however, is trying to frame the risks of these various alternative fixed-income asset sub-classes and portfolios using the same tools that worked for more traditional bonds. The most typical bond fund benchmark, the
Barclays U.S. Aggregate Bond Index, has an approximately 75% allocation to bonds that are guaranteed by the U.S. government, including U.S. Treasuries, mortgage-backed securities backed by government agencies, and the debt of those same government agencies. The remaining 25% is primarily high-quality U.S. dollar corporate and some high-quality commercial-mortgage-backed bonds. It should come as no surprise that this benchmark is highly correlated to the movements of U.S. Treasuries. If the U.S. economy improves and, as so often happens, U.S. Treasury yields rise (and prices fall), the
Barclays U.S. Aggregate will go down in price. In contrast, consider a corporate bond with a credit quality that is only a few notches above a defaulted bond. If the economy improves, it is likely that this low-quality security will go up in price, or in other words, in the opposite direction of U.S. Treasuries. While the quoted duration of this junk bond may be four or five years, because its price movement is not well correlated to Treasuries, an adviser can't use the duration statistic to analyze its sensitivity to changes in high-quality interest rates. Similarly, judging the risk of flexible fixed-income portfolios based solely on their stated duration is a mistake.
Advisers are fortunate to have a widening array of potential investment options in the fixed-income universe. But it is important for them and their clients to recognize that portfolios investing outside the
Barclays U.S. Aggregate opportunity set may perform quite differently from that traditional index. Blindly applying the same set of tools to analyze all bonds and portfolios will lead to confusion, bad investment and disappointment.
Jason Brady is a managing director and portfolio manager with Thornburg Investment Management.
