From this moment, no matter what we do, Titanic will founder.
But this ship can’t sink!
She’s made of iron, sir! I assure you, she can. And she will. It is a mathematical certainty.
First, an observation
You may have seen a shortened version of this article on our blog. There is a reason, beyond sloth, that we are expanding this article. We intentionally avoid hyperbolic overreaction and try to let long-term, strategic concerns dictate the tone of our conversation, both in individual conversations to clients and in these broad market commentaries. Market fluctuations are inevitable and should not cause investors to chase performance, or run-away, on reflex alone.
However, the recent bump in the bond markets reflect a fundamental shift in the foundations of fixed income investment. The impacts we discuss here will affect long-term investment decisions for the foreseeable future. These changes have been predicted for a number of years – since mid-2009 at least – but the impacts have finally begun to occur.
Now that we have framed the significance of these changes, let us back up for a moment and actually describe the changes we are talking about.
Bonds as a Safe Haven
Relative to equities, the bond market has three essential advantages: diversification against equity market direction, lower volatility than equities, and a greater tendency to protect principal. For the first time in a long time, the bond markets are starting to lose material amounts of money. Not since the bear fixed income market of 1994 has the bond market had the opportunity to remind investors that bonds can, and do, lose value.
In general terms, the fixed income categories have outperformed equities in the previous decade given the collapse of the technology driven exuberance of the early 2000s and the fiscal crisis of the late 2000s. Even more broadly, over the past 30 years, bonds have demonstrated a tremendous ability to preserve principal. A key driver of bond market outperformance regards interest rates; for the past 30 years, interest rates have taken a significant downward trend. In simple terms, when interest rates go down, bonds gain market value.
What changed in June?
The problem for fixed income which primarily relies on interest rate movements (like Treasuries or government backed Agencies) is that the short-term interest rate floor for interbank lending (The Federal Funds rate) is already at 0%, so it can’t really fall any further. Furthermore, there has been an additional margin of extraordinary actions taken by the Federal Reserve in response to the financial crisis, beyond simply minimizing short-term interest rates. However, some of these margins may be shrinking and that’s what caused the jump in longer term interest rates. Specifically, the Federal Reserve is signaling a “tapering” down of their extraordinary measures (Quantitative Easing) which support the fixed income market, and they now project an end to the QE program by the middle of next year. This action is a necessary prelude to a potential increase in interest rates. Again, the simplification is when interest rates go up, bonds lose value. Several members of the Fed have dissented from the Chairman’s proposed timelines for interest rate increases and suggest an even more hawkish interest rate policy to contain future inflation, which specifically assails the value of fixed income investments.
To be clear, the Fed consensus for increasing interest rates is still more than a full year away (late 2014-2015), but the bond markets – sensing this shift in tone – have been punishing to investors. Longer term interest rates are more clearly a function of investor supply and demand rather than the short term rate floor set by the Federal Reserve. Thus, despite the absence of any actual change in policy, long term interest rates jumped and the fixed income market took a significant hit during the quarter. It is entirely possible that investors have overreacted to the news (or rather, the non-news, since policy has not changed yet), but a loss for fixed income investors has been rare and may become more common in the years to come.
In short, we are afraid that many bond investors believe that their portfolios are immune from danger, but there is definitely trouble ahead for fixed income investments. It can’t be avoided, but it can be contained.
To do #1: Acknowledge a potential tactical disadvantage
We are afraid that many investors have simply forgotten that bonds can lose value and they are going to be surprised by their June statements. More importantly, an increase of interest rates now seems inevitable and the reversal of this long term bias towards fixed income may disappoint investors. The reasons for investing in bonds continue to exist despite the signs of interest rate increases; for example, even an asset class with a long term return projection of zero might find its way into an optimized, efficient portfolio if it had sufficiently negative correlations to other return-seeking asset types. Still, it is important for investors to recognize the potential tactical disadvantages of classic core bond portfolios. Depending on the ability of an institution to conduct appropriate due diligence, the fixed income mandate for a portfolio may expand to include non-core elements such as core-plus, multi-sector, unconstrained, total return, or global fixed income products which expand the risk and exposure beyond purely interest rate driven risk. Diversifying fixed income exposure to include currency or credit risk may be appropriate for some investors.
To do #2: Revisit your strategic asset allocation
Another other key consideration in the wake of these changes: asset allocation modeling. When determining an optimal asset allocation for a portfolio, analysts typically rely on asset allocation software which uses historical data to figure out optimal portfolios based upon the risk and return profiles of different asset classes. Asset allocation software works by comparing the risk, return and correlation of these asset classes over their longest concurrent timeline. As a reminder, over the past 30 years, interest rates have trended downward, so bond market performance has enjoyed an advantage in these models. In order to have a unbiased comparison of bonds and equities, asset allocation software should include historical data beyond the 30 years in which interest rate trended downward. The problem, however, is relatively new and significant asset classes – Emerging Markets, Hedge Funds and so forth – may not have historical returns greater than 30 years. Thus, asset allocation software has a built in structural bias because of the interest rate trend. Therefore, the optimized models may exist with over-allocations to fixed income. Investors should double-check their strategic allocations to see if their strategic allocation makes sense. Consultants using asset allocation software should disclose and, if possible, account for this bias.
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