A Return to Traditional Asset Allocation
Whether or not the fixed-income bull market of the past thirty years has come to an end, the market itself has meaningfully changed over the past four years as many investors increased leverage and credit exposure to chase returns. While some investors are becoming more attuned to the impact of these changes, others have not discovered how the risks in their portfolios evolved. This paper explores the changes in the post-recession fixed-income market and what investors should consider as they reposition their portfolios for the upcoming year and beyond.
Setting the Stage: br>
How Quantitative Easing Distorted Risk
During this summer’s taper scare, the merits of the Federal Reserve’s Quantitative Easing program were argued and rehashed at length, with a focus on whether it was effective in stimulating growth and employment. While the debate continues in most regards, it’s clear that the program was very successful in pushing investors out on the risk spectrum.
Determining why this happened is simple: each new round of Quantitative Easing drove term rates to new lows. All-time low yields translated into all-time high bond prices. From 2009 through 2012, 86% of actively managed funds benchmarked to the U.S. Barclays Aggregate Bond Index outperformed the benchmark, thereby generating stellar returns and attracting new investors.2
As returns soared and investors shied away from equity investments, new money poured into the bond market. It’s estimated that inflows totaled approximately $380 billion in 2009, $235 billion in 2010, $125 billion in 2011 and $304 billion in 2012.3 As these inflows were invested, the virtuous cycle accelerated: increased demand for securities drove prices even higher and yields even lower. This demand pushed yields on the safest assets well below the long-term rate of inflation, so to continue producing outsized returns, investors sought higher yields and, therefore, riskier assets.
“...the magnitude of these flows [into] the bond market indicate that investors were incrementally investing their portfolios in bonds while the economy grew and corporate returns were robust.”
Ultimately, the bond market produced outsized gains for several years, mostly due to price appreciation, as yields undulated lower. The Lipper A-Rated Bond Fund Average returned 6.80% in 2011 and 7.09% in 2012.4 Over the past five years, the Barclays U.S. Aggregate Bond Index returned 30.14% in total and 5.41% on an annualized basis.5 Returns on the riskiest securities, including high yield bonds, soared even higher. The Barclays U.S. Corporate High Yield 2% Issuer-Capped Index returned 22.05% annually from 2009 through 2012.6 Moreover, the returns increased as investors slid down the quality scale; in the past 12 months, the return on Caa credits is nearly three times the return on Ba credits.7
How the Paradigm Shifted
During the bond market’s rise, more subtle changes occurred that are having a substantial impact on returns, future allocations and the understanding of risk. In particular, reliance on leverage, derivatives and higher-risk securities increased, exposing investors to higher levels of volatility and possible losses, as momentum reverses in the fixed-income markets.
During the first stage of the economic recovery, investors reversed their mindset on the typical risk and reward balance between bonds and equities. In the equity market, investors began purchasing stocks for their dividend yields, which were often well in excess of the yields available from fixed-income assets. Conversely, because of the excitement generated by bond market gains, and the signals from the Federal Reserve that term rates would remain depressed for years to come, investors turned to fixed-income instruments for capital appreciation despite naturally range-bound returns.
“...reliance on leverage,
derivatives and higher-risk
securities increased, exposing
investors to higher levels of
volatility and possible losses...”
As is typical in a bull market, the drive for returns eventually led to increased risk-taking. The goal for fixed-income investors was no longer “principal preservation” with “risk-balanced income” but simply “yield.” In an effort to stay with the pack, investors purchased riskier assets and increased leverage on individual securities and at the fund level. Many bond funds—including investment-grade funds—pulled these levers to magnify returns. There were many beneficiaries of this market action, including troubled European sovereigns, emerging markets and companies of marginal credit quality, as well as investors in those funds.
Finally, top-down asset allocation by investors became skewed. In contrast to the previously mentioned inflows into the bond market, the equity market struggled with outflows in both 2011 (approximately $128 billion) and 2012 (approximately $153 billion).8 In fact, outflows between 2007 and 2012 totaled approximately $600 billion.9 Reasons for the exodus aside, the magnitude of these flows in context of the flows into the bond market indicate that investors were incrementally investing their portfolios in bonds while the economy grew and corporate returns were robust.
Lessons Learned from the Summer of 2013
The Federal Reserve’s rhetoric this summer concerning its desire to reduce, and eventually remove, Quantitative Easing exposed the risks within this new investment scheme. Just before that rhetoric began, the ten-year Treasury dipped to 1.63%.10 The ten-year Treasury has had a historical relationship with both the rate of inflation and the rate of GDP growth, but this yield dramatically violated both associations. Annualized GDP growth in the first quarter of 2013 was 1.8%.10 Based on historical relationships, this level of growth should have led to a ten-year Treasury rate of approximately 3.3%, or 1.5% above GDP growth.10 Similarly, the inflation rate ranged between 1.0%-1.5%, and with history as a yardstick, this should have led to a ten-year Treasury rate of 3.0%-3.5%.10 In addition to the ballooning size of the Federal Reserve’s balance sheet, this outsized disruption in the markets necessitated a change.
The possibility of a reduction in stimulus by the Federal Reserve once again shifted the evaluation of risk and reward, and investors briefly took note of where they stood on the risk spectrum. This realization pushed investors toward the exit, causing values to plunge and yields to spike higher. Between May 1st and August 31st, the Barclays U.S. Aggregate Bond Index lost 3.81% of its value.11 The impact was even more severe in the high yield markets, where values fell 5.36% during the most intense portion of the summer (but finished August down only 2.33%).9
The risk embedded within many fixed-income funds quickly went from latent to active, as funds more heavily reliant on riskier assets, derivatives and leverage dramatically underperformed the market. The data perfectly demonstrate the risk within these funds: from May 1st to August 31st, when the market was most concerned about rising interest rates, the ten largest intermediate-duration bond funds lost an average of 6.51%.10 Recall that the Barclays U.S. Aggregate Bond Index lost 3.81% during the same period, and the Bloomberg High Yield Corporate Bond Index lost only 2.33%. All of the largest funds use both derivatives and leverage—in some cases up to 30% of the portfolio. While these tools certainly pushed returns higher during the post-recession euphoria, these same features amplified losses in a rising rate environment. Perhaps most importantly, these returns demonstrate that there are major discrepancies in risk profiles between funds.2
“...funds more heavily reliant
on riskier assets, derivatives and
underperformed the market.”
Since non-traditional funds saw notable inflows during the autumn, it raises concerns that certain investors may not be aware of these differing risk profiles and, therefore, could be exposed to a repeat of last summer’s events.
A Return to Traditional Bond Investing
The basis of bond investing lies in the return of capital and the collection of income—it dictates the structure of indentures offered in the market and has provided stability for centuries. Inherent to this structure is the fact that, under normal market conditions, investors should expect to earn only the income provided by the bond itself. The goal of an actively managed fund is to add additional returns through the selection of well-priced bonds, or bonds expected to outperform peers over the intermediate-term. It is this tenet that provides the benefits of fixed-income investing: capital preservation and income generation.
Because fixed-income returns are naturally range-bound, outsized capital appreciation is usually only achieved and sustained via bond investments when risk is added, thereby negating the goal of capital preservation. In short, the same features that amplify returns in an appreciating market then accelerate losses in a depreciating market. Instead, investors should seek capital appreciation through equity investments since coupons are not preset, and investors can fully participate in earnings growth.
“Outsized capital appreciation
is usually only achieved and sustained via bond investments when risk is added, thereby negating the goal of capital preservation.”
In a parallel to the housing market, it was leverage and risk-taking that finally exposed the fixed-income market’s weaknesses. Leverage is detrimental to assets designed to preserve capital—it can magnify the wrong thing at the wrong time, and is especially difficult to control.
The Investor’s Principal
While the flow of assets from the equity market to the bond market indicates an asset allocation shift at the micro level, it does not fully explain the creation of a virtuous cycle in the bond market, nor why values shifted so abruptly during the summer. In fact, some periods of falling values are characterized by outflows, like the equity markets during 2008 and 2009, whereas other periods of outflows coincide with gains, such as the equity markets between 2009 and 2012. Instead, the marginal willingness to pay for any given security determines the impact of the flows. During the bond market bull-run, inflows outpaced supply, and investors hunting for yield paid an increasing premium above par. As an example, an investor who now has $110 to invest versus $100 previously has an incremental willingness to pay of $10. Therefore, that same investor may pay a premium for a higher-yielding bond simply due to his increased capacity to do so.
In this case, the principal on the bond remains $100, however, the value invested, or the “Investor’s Principal,” is $110. Should interest rates rise, the marginal willingness to pay decreases, or the intrinsic value of the bond declines due to a credit event, the bond’s value could easily fall. While the issuer has not defaulted and the bond’s principal was preserved, the Investor’s Principal was lost. These two concepts, that bond losses can occur without defaults, and that the intrinsic value of a bond may not be par, were deemphasized during the chase for yield and, therefore, put Investor’s Principal at risk.
The incremental willingness to pay and Investor’s Principal are especially important because the use of leverage and derivatives increased the available capital even further. Therefore, the marginal willingness to pay increased further, again contributing to the virtuous cycle. During the summer, losses were exacerbated at certain funds because the assets they held lost the incremental buyer, and the intrinsic value declined. Facing redemptions, levered funds were forced to liquidate positions, resulting in declining prices and an erosion of Investors’ Principal. Once again, leverage, derivatives and the investment in higher-risk assets increased volatility and risk.
The Path Ahead
From here, investors should take a balanced approach to their review of fixed-income investments. Fixed-income will remain the foundation of a balanced portfolio, so rather than exit the bond market altogether, investors should closely examine the structure of their existing holdings to ferret out risks. A critical starting point for investors is to review each fund’s prospectus to determine its goalposts for risk-taking.
Despite today’s challenging interest rate environment, certain bond funds should be able to realize gains. Funds with shorter durations and a barbell-shaped maturity profile typically do well during periods of rising interest rates. When asset maturities are in a barbell shape, a meaningful percentage mature within the next 24 months, allowing those proceeds to be reinvested at then-higher rates of return.13
For nearly all investors, the foundation of a diversified portfolio is an investment-grade (or low beta) bond fund.14 Traditionally this is defined as a fund that is not levered and has limited, or no, derivative usage, and no equity holdings. Conservative bond management focuses on preserving Investor’s Principal. To do so, an investment must have two components: first, it must have high intrinsic value that will attract the incremental investor; and second, it must minimize or eliminate the shocks associated with leverage or credit risks. While derivatives can be used to hedge risk, the opposite can be true as well, since fund managers can use derivatives to compound the impact of their bets. Fixed-income funds that include equity investments, heavy use of leverage and/or derivatives may be a component of a balanced portfolio, but likely lack the core attributes essential to creating a strong foundation.
“For nearly all investors, the
foundation of a diversified portfolio is an investment-grade bond fund.”
Having established this base through a conservative, investment-grade bond fund, investors should seek out capital appreciation through equity strategies, while being cognizant of risks and incentives for all of their investments.
1Past performance is not necessarily indicative of future results.
2The Vanguard Group, Inc.
3Strategas Research Partners, LLC; Investment Company
4Lipper (Thomson Reuters)
5Barclays PLC; Bloomberg L.P.
6Barclays PLC; Bloomberg L.P.
7Barclays PLC; Bloomberg L.P.
8Investment Company Institute; Bloomberg L.P.
9Strategas Research Partners, LLC
10Source of data is Bloomberg L.P., calculations performed
by Parnassus Investments.
12Source of data is Bloomberg L.P., includes data from
the largest funds with publicly available data. Calculations performed by Parnassus Investments.
13Fabozzi, Frank. Fixed Income Analysis (2nd Edition). New Jersey: Wiley, 2007. Print.
14Graham, Benjamin. The Intelligent Investor. New York: HarperBusiness, 1973. Print.