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Many investors need to maintain rate-of-return targets to meet ongoing spending needs and satisfy other liabilities, but may face significant hurdles in achieving these targets given current market valuations and the low level of global bond yields. Choosing the right mix of assets to maintain prudent diversification while still striving to meet these rate-of-return targets can certainly present challenges. Here are five reasons why we believe fixed-income should continue to be an important part of investors’ portfolios.

  • 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 0.78 to 0.91. 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 -0.4 to 0.1. This range suggests that fixed-income is either not correlated or negatively correlated 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)
    Fixed Income Exihibit 1
    Source: Morningstar Direct. As of 31 Mar 21. Select the image to expand the view.
  • While we acknowledge that potential returns for fixed-income may appear to be limited in the current market environment, investors should consider whether designating some capital to fixed-income is an efficient allocation considering the modest risk profile of the asset class (i.e., standard deviation of annual returns). Exhibit 2 illustrates the return/risk ratio for various asset classes for the trailing five years (all returns annualized). The return/risk ratio for the Bloomberg Barclays Global Aggregate Index (FX Hedged) (Global Aggregate Index) is 1.16—this is the most efficient allocation across the major asset classes shown in Exhibit 2.

    Exhibit 2: Return Per Unit of Risk, 5 Year
    Fixed Income Exihibit 2
    Source: Morningstar Direct. As of 31 Mar 21. 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 Global Aggregate Index and the option-adjusted duration (OAD). It’s true the investable characteristics of the Global Aggregate Index in early 2020 probably looked somewhat unattractive to investors, but Exhibit 4 illustrates how the Global Aggregate Index returned 5.58% for the calendar year 2020. The return on the Global Aggregate Index clearly outpaced private equity. So, in a year (2020) when many investors questioned the return prospects for fixed-income, the Global Aggregate Index returned 5.58%.

    Exhibit 3: Global Aggregate Index—the Duration and YTW Relationship
    Fixed Income Exihibit 3
    Source: Bloomberg Barclays. As of 31 Mar 21. Select the image to expand the view.
    Exhibit 4: 2020 Index Returns
    Fixed Income Exihibit 4
    Source: Morningstar Direct. As of 31 Mar 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 developed market government bonds as ballast in portfolios or inflation-linked bonds 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 a 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.

    Indeed, global bonds have produced positive returns in all major “risk-off” periods for equities since the inception of the Global Aggregate Index in 1997 (using monthly data) to the most recent downturn in 1Q20 (Exhibit 6). While the hedging characteristics of long-dated US Treasuries are even more powerful, long-dated US Treasuries exhibit much greater volatility versus a diversified portfolio of global bonds such as the Global Aggregate Index.

    Exhibit 5: Avoiding a Drawdown Death Spiral
    Fixed Income Exihibit 5
    Source: Bloomberg. As of 31 Mar 21. Select the image to expand the view.
    Exhibit 6: Fixed-Income Can Serve as an Effective Risk Mitigation Tool
    Fixed Income Exihibit 6
    Source: Bloomberg Barclays, ICE BoA Merrill Lynch, Western Asset. As of 31 Mar 20. Using Monthly Data from Jan 97 to Mar 20. Select the image to expand the view.
  • Over the last 10 years, the Global Aggregate Index has generated a cumulative total return of 47.18%. A little-known fact behind this number is that the cumulative contribution from the income component is 31.35% (or 66% 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 of global bonds (currently at 1.16%*) to the dividend yield of the equities. While it’s true that the current dividend yield of the S&P 500 is 1.46%*—roughly 25% more than the yield on the Global Aggregate Index—capturing that dividend yield means investing in an equity index that has exhibited an annualized volatility of 13.4% for the last 10 years (as compared to the Global Aggregate Index that has posted annualized volatility of 2.7%*). Currently, the Global Aggregate Index produces an annualized coupon of 2.32%, 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 Global 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.

    *As of 31 Mar. 20.
    Exhibit 7: Risk vs. Yield
    Fixed Income Exihibit 7
    Source: Bloomberg. As of 31 Mar 21. Select the image to expand the view.
Webcast: why fixed income still matters
WEBCAST: Why Fixed-Income Still Matters–Inflation Expectations and the Great Reopening
This dynamic roundtable discussion highlights the reasons why we think fixed-income should be considered an essential pillar of every successful long-term portfolio, regardless of the current low-yield environment.
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