5 Reasons
Why Fixed-Income Still Matters

The correlation of risk assets to one another (Exhibit 1) highlights the importance of selecting diversifying assets. Over the past several years, it’s been very popular for institutional investors to allocate significant percentages to hedge funds and private equity; however, we would note that the correlation to public equities ranges from 0.76 to 0.92. The trailing five-year correlation of the S&P 500 with non-US equities ranges from 0.77 to 0.88 and is highly correlated by any definition. The only asset that demonstrates a low to negative correlation to risk assets is fixed-income. Here, the range of correlations for traditional fixed-income ranges from -0.40 to 0.00. This range suggests that fixed-income is either not correlated (0.00) or negatively correlated (-0.40) relative to traditional risk assets. This underscores the importance of using fixed-income as a diversification tool.

As always, there’s little visibility regarding what may actually happen over the next six to 12 months. This means it’s difficult to know which asset class will outperform and which one can act as the best portfolio hedge. As a result, portfolio diversification still matters—it always has and always will. The rate of return is an important consideration, but so is risk management given perennial uncertainty. Effective risk management starts with appropriate diversification. And there’s no better diversifying asset class than fixed-income.

Exhibit 1: Return Correlation Matrix (5 Years)

Source: Morningstar Direct. As of 31 Dec 20. Select the image to expand the view.

It’s important to bear in mind that uncertain markets can translate into volatility that, in turn, can produce returns well above what a security may be yielding at the time. For instance, Exhibit 3 shows the historical relationship between the yield-to-maturity for the BB US Aggregate Bond Index and the option-adjusted duration (OAD). It’s true the investable characteristics of the Aggregate Index in early 2020 probably looked somewhat unattractive to investors, but Exhibit 4 illustrates how the BB Aggregate Index returned 7.51% for the calendar year 2020. The return on the BB Aggregate clearly outpaced private equity and hedge funds. So, in a year (2020) when many investors questioned the return prospects for the BB Aggregate, it returned 7.51%.

Exhibit 3: BB US Bond Aggregate Index—the OAD and YTM Relationship

Source: Bloomberg Barclays. As of 31 Dec 20. Select the image to expand the view.

Exhibit 4: 2020 Index Returns

Source: Morningstar Direct. As of 31 Dec 20. Select the image to expand the view.

There are few asset classes that can mitigate drawdown risk while providing income/return potential and liquidity. For example, commodities such as gold offer no income source. Alternative asset classes such as real estate or private credit may offer long-term return potential, but these asset classes come with difficulties related to estimating valuations and are highly illiquid. Also, while there has been a clear bias toward private credit in recent years as investors hunt for yield, have investors really seen how those investments will perform during a prolonged bear-market scenario? With public fixed-income, investors can use US Treasuries as ballast in portfolios or TIPS to hedge against rising rates—both of these markets are deep and liquid. For investors with a greater risk tolerance, they can hold an allocation to floating-rate corporates or bank loans, both of which offer income as well as some degree of protection in a rising-rate scenario.

As a stark reminder, the Dow Jones Industrial Index high point early in 2020 was at 29,511 on February 12 but closed at 18,591 on March 23—a 37% drop in about 40 days. Conversely, the 30-year Treasury yield hit its 2020 peak of 2.38% on January 9, 2020. This may have seemed unattractive to the novice investor, but in terms of diversification and return potential, holding the 30-year Treasury bond was a winning proposition. It hit an all-time low of 0.99% on March 9, 2020, which netted more experienced investors a handsome 32% return.

Exhibit 5: Avoiding a Drawdown Death Spiral

Source: Bloomberg Barclays. As of 31 Dec 20. Select the image to expand the view.

Over the last 10 years, the BB US Aggregate Bond Index has generated a cumulative total return of 45.76%. A little-known fact behind this number is that the cumulative contribution from the income component is 36.73% (or 80% of the total return).

Any investor (retail or institutional) needs repeatable income to meet ongoing expenses, pension payments, etc. As part of their asset allocation exercises, investors often compare the yield on the 10-year Treasury (currently at 1.07%*) to the dividend yield of the S&P 500. While it’s true that the current dividend yield of the S&P 500 is 1.60%*—roughly 50% more than the yield on the 10-year Treasury—capturing that dividend yield means investing in an equity index that has exhibited an annualized volatility of 13.5% for the last 10 years (as compared to the BB US Aggregate Index that has posted annualized volatility of 2.9%*). Currently, the BB US Aggregate Index produces an annualized coupon of 2.76%* (again, not compounded). The actual yield-to-maturity of the Bloomberg Barclays Aggregate Index is currently 1.14%.* But, it’s important to remember that markets can reset yields and spreads materially higher in a short period of time (e.g., witness the spread widening during March 2020). It’s fair to say that the BB US Aggregate Index (or any specific fixed-income sector) should continue to produce much-needed income regardless of the market environment, yield and spread levels. What’s more, despite the low levels of yields on a historical basis, fixed-income still delivers attractive returns and low volatility—and its income remains a big driver of overall total return. These are all critical variables for investors at or near retirement age and for large institutions meeting their obligations.

Exhibit 6: Risk vs. Yield

Source: Bloomberg. As of 31 Dec 20. Select the image to expand the view.