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Bond market perspective: Why it’s important to stay strong at the core
Mike Gitlin
Margaret Steinbach
Ritchie Tuazon
April 23, 2020
KEY TAKEAWAYS
- Fixed income valuations were stretched before this volatile period
- Many years of excesses need to unwind as leverage remains high
- A core bond portfolio should provide diversification and capital preservation
Needless to say, it’s an unusual time. We won’t add to the noise that “markets are volatile” or make other obvious statements. Rest assured, we see that reality and are working hard to manage through the challenges associated with dislocated and somewhat illiquid markets.
The reset in asset prices over the past several weeks has been driven by the fear of an economic downturn. As we move forward, the driving force behind the continued reset will be the reality of much weaker growth and sharply lower corporate earnings.
We know from past downturns and periods of volatility that often the best course for investors is to stick to their individual plans. In equities, popular wisdom argues that you should maintain a long-term focus, stay invested and take advantage of dollar cost averaging through the downturn.
In bonds, however, now is the time to take a closer look at what you own.
Interest rate outlook: Lower for even longer
We’ve been preaching “lower for longer” for years. In March, U.S. Treasury yields reached new all-time lows as the U.S. Federal Reserve cut its policy rate to 0.00%–0.25%. With the return of zero interest rate policy, the discussion of negative rates in the U.S. will begin in earnest.
It’s not our base case that we see a negative policy rate in the U.S., but everyone should be prepared to hear more noise on this front. Although U.S. rates are closer to the zero lower bound now, they still have room to fall if, for instance, the recovery takes longer than expected.
Leverage remains high
During a recessionary period, we know credit becomes challenged. Our starting point adds to the difficulty: Going into this downturn, the riskiest segments of the credit market (BBB-rated investment-grade corporate debt, high-yield credit and leveraged loans) had reached a 20-year high as a percentage of U.S. GDP at 25%. Notably, BBB debt as a percentage of the investment-grade credit market had also ballooned to roughly 50% of that universe
Working through this imbalance will take time. We also expect the unwind and repricing of risk in the market will continue to be exacerbated by a lack of liquidity. In the initial price decline, banks quickly reached balance sheet risk limits. Investors who have been blindly riding the credit wave for years haven’t been able to unwind, even if they wanted to do so.
The lack of liquidity has been more severe in this downturn compared to the 2008–09 financial crisis. Measures have been taken to alleviate stress in the system, and they’re helping, but it’s unlikely that we will see markets return to their pre-COVID-19 complacency.
Excesses need to unwind
As spreads in corporate credit have widened substantially, we are now less defensively positioned, but we remain risk aware as we evaluate new opportunities. Years of excesses still need to unwind. We will ultimately find value, as we did in recent weeks when credit spreads — the difference between yields offered by U.S. corporate debt and U.S. Treasuries — hit their widest levels. We will continue to take advantage of opportunities on a security-by-security basis, viewed through the eyes of our experienced analysts.
We’re still mindful that we’re likely to shift from the “hope” that’s driven the recent rebound in asset prices to the “reality” stage reflecting the weak current state of our economy. With a lot still unknown, spreads have the potential to move wider again, notwithstanding central banks that have gone all-in, particularly in those areas of the market that were not previously supported by central bank purchases or lending programs. Over time, further credit spread widening may present attractive entry opportunities.
Stay strong at the core
In previous commentaries, we’ve talked about considering “upgrading the core” of your fixed income allocation. That message is more relevant today than ever. Our view is that now is the time to stay strong at the core, remain risk aware and avoid the temptation to reach for yield. Even with historically low U.S. Treasury yields, it’s not too late to make sure your bond portfolio is doing what it should — providing diversification from equity exposure and preserving capital.
During this volatile period, many investors have been surprised to see their bond funds fail to perform their intended role. For example, all five of the largest core-plus bond funds available in the U.S. declined in the month of March, posting an average loss of 3.3%. And even some short-term bond funds have struggled, producing negative returns in this environment.
Be mindful that bond funds with “core plus,” “total return” or “income” on the label tend to be overweight lower rated corporate credit, emerging markets debt and structured products, and they can be significantly underweight U.S. Treasuries. These types of funds can be important components of an overall bond allocation if they are part of a well-diversified bond portfolio.
The truth is, no one knows what will happen next. But you can focus on making sure that as the highs and lows of these volatile times continue, your fixed income portfolio is designed to absorb the shocks and help provide a measure of stability when you need it most.
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