A Sea of Change in Fixed Income By: Gabriel PotterMBA, AIFA®

Bonds as a Safe Haven

Relative to equities, the bond market has 3 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 generally, over the past 30 years, bonds have demonstrated a tremendous ability to preserve principal. A key driver of bond market out performance 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 value. 

What changed? 

The problem for fixed income that primarily relies on interest rate movements (like Treasuries or government backed Agencies) is that interest rates can’t really fall any further. 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 a hawkish interest rate policy to contain inflation. 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 the shift in tone – have been punishing for investors. 

First: 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 the next month’s 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 are not completely absent now that there are 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 multi-sector, unconstrained, total return, or global fixed income products which expand the risk and exposure beyond interest rate driven risk. 

Second: 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, consultants often rely on asset allocation software which uses historical data to figure out optimal portfolios based on the risk and return profiles of different asset classes. Asset allocation software works by comparing the risk, return and correlation of different asset classes over their longest concurrent timeline. Again - over the past 30 years, interest rates have trended down so bond market performance has enjoyed a structural advantage. In order to have a fair comparison of bonds and equities, asset allocation software should historical data beyond 30 years the downward interest rate trend, which otherwise would bias the results. The problem, however, is relatively new and significant asset classes – Emerging Markets, Hedge Funds and so forth – do not have historical returns greater than 30 years. Thus, asset allocation software has a built in structural bias because of the interest rate trend. Investors should be wary of this bias and check to see if their asset allocation decisions have incorporated this bias. Consultants using asset allocation software should disclose and, if appropriate, account for this bias.

 
Gabriel Potter

Gabriel is a Senior Investment Research Associate at Westminster Consulting, where he is responsible for designing strategic asset allocations and conducts proprietary market research.

An avid writer, Gabriel manages the firm’s blog and has been published in the Journal of Compensation and Benefits,...

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