Venk Reddy has an article on Advisor Perspectives, Robbing 2020 to Pay 2019: A Reality Check for Fixed Income, and it needs to be read! We’ve been screaming about the issues with bonds and the implications moving forward with our advisors, Venk unpacks similar sentiment much better than we can in his article, but we had to chime in with quick thoughts here.
What we believe to be the issues with bonds… The first would be potential return. The second would be the risk associated with return.
When returns are probably low and risk probably high – that combination can screw up a portfolio with a sizable allocation – which is nearly every portfolio we see in our day to day interactions with advisors.
If you own bonds, primary drivers of returns are the following: Yield, or interest income (the coupon) and change in bond prices. Think about today’s bond market:
- Yield/Income: You’re receiving historically low yields…I’m talking a 10 year treasury yielding 1.50%. Factor in inflation of 2%, which is a questionable assumption, and you’re losing money on that.
- Positive Price Change: Bond prices seesaw with interest rates. Rates down, bond prices up. Rates up, bond prices down. For example, say I issued a $100 bond to you with an interest payment of 3% for 5 years. You give me $100 and I have to pay you $3 a year for 5 years and then give you that $100 back. Well, if 6 months from now, the going 5 year rate is only 1.5%…the bond your holding is much more attractive and anybody looking for yield will pay you a premium for that higher coupon. Again, can rates go lower…sure, but how much lower? We’d argue the juice has been squeezed.
The bond math is ugly.
Like anything investing, if you want to make the math look better by positioning for higher return, you must take additional risk. In bond land, you can take more credit risk or more duration risk. What the heck are those? Good question.
- Here’s Investopedia on credit risk: “Credit risk is the possibility of a loss resulting from a borrower’s failure to repay a loan or meet contractual obligations.” In other words – you can find higher yields, but those higher yields come with strings attached. Remember, in a world with treasury yields and S&P dividend yield below 2%, if you find outsized yield, make sure you understand the added risk. As we say, stated yield is not always realized yield!
- Duration risk is a fancy way of saying sensitivity to interest rate changes. In other words – more duration risk means greater movement in the price of bonds when interest rates change. If they go down, it’s good to have duration risk, if they go up, it’s bad.
Here’s the bad news. Investors are now being compensated at historically low levels for taking on these additional risks. Said another way, we believe it ain’t worth it.
To close, bond returns of the past (specifically the recent past) have been great. But, those returns have most likely robbed future returns. Venk says it better than us when talking about recent bond returns:
“We fear that, rather than acknowledging their good fortune, investors are doubling down on it happening again. But the last time the market has seen two consecutive years in which the Agg has delivered over 5% total return was 2010/2011. The current economy is a very different level of risk than the one we saw just after the financial crisis. Rather than cheer the 2019 gain in fixed income and pat themselves on the back for a job well done, investors should realize that some of what should have been 2020’s performance was pulled back into 2019 in most duration-unconstrained strategies. This has reduced the already small cushion investors have if things don’t go as they expect… and maybe even if they do.”
Last thing we will say is that it is important to remember what historically has driven fixed income returns versus what drove them in 2019. Can rates continue to free fall downward while credit spreads tighten and re-create new historic lows? When building our return assumptions for 2020, we look at the current average yield of the Barclays Aggregate (which is 2.20%) as an indicator of the most probable total returns. From that perspective, it is easy to see that 2019 was an anomaly.