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AAM Viewpoints – Now is Not the Time for Bonds? Not So Fast!

With interest rates recently touching multi-year highs, credit spreads near or at post-crisis lows and the return of volatility to both equity and fixed income markets, concerns over a “bond bubble” have, again, become the “topic du jour1.” There are a whole host of factors that point to higher rates moving forward including current monetary policy, recent fiscal stimulus, concerns over inflation and deficit spending and prospects for improving global growth both here in the United States and abroad. Recent fund flow data seems to reflect the markets concern with bond fund and fixed income exchange traded fund flows slowing significantly in the last two months of Q1 (1st quarter) 20182. One would be remiss not to take notice of the recent increase in risk to the upside regarding interest rates and what that could portend for fixed income. Still, investors should also exercise caution not to paint markets with a broad brush. 

For lower risk tolerance, long-term investors looking for principal preservation and income, now could be the worst time to exit fixed income. While the risks posed to fixed income markets by factors such as higher rates and concerns over credit quality should be noted, understood and accounted for, they neither preclude nor are they mutually exclusive of the use of fixed income as a tool for long-term principal preservation and income in today’s volatile environment. Specifically, for clients with higher tax liabilities, a defensively positioned portfolio of municipal securities can do an admirable job of protecting principal when rates rise, can be structured to take advantage of higher yields and have the potential to provide a ballast to equity market volatility while generating attractive levels of income, in our opinion. 

The concern over a bursting bond bubble is more properly stated as concern over the interest rate risk currently embedded in many areas of the fixed income markets. With higher rates come lower bond prices and because the asset class most susceptible to interest rate risk is also the safest from a credit risk standpoint – namely U.S. Treasuries – one can understand why there is concern and consternation across all fixed income markets. Rightly so. The current 30-year Treasury matures in February 2048, carries a 3% coupon and has a duration of 19.8 years. Duration can be interpreted as a measure of sensitivity to interest rates. For a 100 basis point move up in rates, a 19.8-year duration implies one could lose as much as 19.8% in principal value or over six years’ worth of coupon income, depending upon how quickly rates were to increase. That would represent volatility in the world’s safest bond market of an order most advisors have never experienced. Investors should be concerned, should take note and should structure portfolios accordingly. 

One of the fundamental truths to investing in fixed income for preservation of capital and income is that long-term returns are driven by time in the market and not timing the market. This holds true regardless of the prevailing interest rate environment. Price changes on bonds or “price returns” are generally not a long-term contributor to total returns especially when considering high grade bonds used for capital preservation and income. The Bloomberg Barclays Municipal Bond Aggregate, since 12/31/1999, carries a total return of 142.968% of which 4.36% came from “price return” and 138.77% came from coupon or “income” return. For a conservative fixed income investor there is nothing that trumps time in the market and leaving monies on the sideline at this critical juncture could do more harm than good, in our opinion. We believe the elixir for fixed income market price volatility is income. We believe staying invested defensively and clipping a coupon is likely the best course of action to offset potential rate volatility. 

Defensively positioning portfolios to generate income and mitigate potential interest rate volatility is an on-going iterative process. We would pay close attention to portfolio structure in today’s rate environment. Specifically, we would deploy a bond ladder based on the investor’s appetite for interest rate risk with a 1- to 12-year bond ladder being our preferred stance for conservative risk tolerances. Short to intermediate bond ladders have, historically, done a commendable job of capturing a substantial portion of longer dated returns with significantly less interest rate risk.  In addition, shorter term maturities rolling off a bond ladder are reinvested at the prevailing level of interest rates which can assist in reducing price volatility and allow the portfolio to keep pace with higher rates. 

Diversification across maturities can help to reduce interest rate risk much like diversification across issuers and revenue source can mitigate credit risk. In diversifying maturities, we would also keep a close eye on duration. While we would position duration defensively, it is important to keep in mind that duration can also be used to gauge how much of a ballast your fixed income provides during periods of equity market volatility. Where rates fall, higher grade fixed income is generally looked to as a safe haven. We believe investors need some duration to provide ballast. We structure conservative portfolios in the 3.5- to 4-year duration range, in today’s environment, as we feel it provides a balance between mitigating interest rate risk and providing some ballast to equity market volatility. In rounding out portfolio allocation, we would look to maximize income or coupon. Higher coupon bonds tend to be less sensitivity to interest rates and have the potential to provide higher cash flows for reinvestment, which can be of benefit in a rising rate environment. 

Finally, we would suggest actively pursuing bond swaps to enhance portfolio characteristics, maintain a static duration and manage against the potential for higher rates. Bond markets tend to run in long-dated secular cycles and we believe the last bond bull market has made it rather easy to avoid mistakes in fixed income portfolios. If we are indeed in a bond bubble, with a shift to a secular bear market, active management becomes more important than ever to avoid credit pitfalls, maximize current cash flows, manage a static duration to maximize total return and manage to help offset the effects of higher rates. Investors should exercise caution in the current rate environment. But, investors also need to avoid painting markets with a broad brush. We believe that recognizing that it is through time in the market and defensively positioning portfolios that investors can best prepare for higher rates.

 

1. Oh, S., & Sunny Oh. (2018, January 09). Bill Gross says bond bear market 'confirmed' amid Treasurys selloff. Retrieved April 04, 2018, from https://www.marketwatch.com/story/bill-gross-says-bond-bear-market-confirmed-amid-treasurys-selloff-2018-01-09 & Belvedere, M. J. (2018, March 01). Ex-Fed Chairman Alan Greenspan: 'We are in a bond market bubble' that's beginning to unwind. Retrieved April 04, 2018, from https://www.cnbc.com/2018/03/01/ex-fed-chair-greenspan-we-are-in-a-bond-market-bubble.html 

2. (2018, April 04). Retrieved April 04, 2018, from https://www.ici.org/research/stats/flows

 

CRN: 2018-0402-6530 R

This commentary is for informational purposes only. All investments are subject to risk and past performance is no guarantee of future results. Please see the Disclosures webpage for additional risk information at commentary-disclosures. For additional commentary or financial resources, please visit www.aamlive.com.

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Effective, June 10, 2016, please note that Gene Peroni left Advisors Asset Management (AAM) to become President of Peroni Portfolio Advisors, Inc. Peroni Portfolio Advisors, Inc. ("PPA") is an investment advisor independent of AAM.