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Financial Industry Insights from Advisors Asset Management

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AAM Viewpoints – Look Beyond the Volatility to Find Return


Periods of volatility in fixed income and equity markets are nothing new but with each one comes a parade of teeth gnashing and hand wringing by experts extolling the virtues of selected investments while simultaneously predicting events often referred to as being much more dire than those we are experiencing at the moment. It seems, more often than not, that such bold predictions make for good headlines but rarely for investment results. When coupled with a bias to think that all economic events are as torrid as the most recent recession, the investment comments become a series of cascading and incrementally more important “breaking news” and “alerts.” As I wrote last year, when everything is breaking news, nothing is.


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Source: ICE BofA ML | Past performance is not indicative of future results


Specious media commentary on market turmoil may drive viewership, but it often ignores (intentionally or casually) the historically documented reasons for returns. Though it may seem trite, you have often heard many at Advisors Asset Management discuss “time in the market” instead of “timing the market.” Short-term volatility has the potential to cause an investor to question whether they should run for the exits or maintain a strategy consistent with their long-term goals. We continue to emphasize the importance of this investment strategy because we are firmly committed to the notion that returns on investments are driven not by wholesale selection of entry and exit periods, but rather by an incremental approach rooted in the careful understanding of the drivers of asset returns. This means understanding the critical role which income plays in fixed returns over the long run, though we are all hardwired to think in the short run.


As is clear by the next two charts depicting a selection of broad ICE BofA ML (Bank of America Merrill Lynch) Indices, fixed income has performed well on a MTD (month to date), QTD (quarter to date), and YTD (year to date) basis. In addition to this robust performance, all but one index has reversed the carnage caused by the market capitulation of the 4th quarter (Q4) of 2018.


Each of these broad indices, except for CCC & lower now have positive trailing 12 month returns. This is certainly impressive considering broad economic uncertainty which began in the rate markets last fall, but are also impressive because of the uncertainty related to Federal Open Market Committee’s (FOMC) actions going forward. As can be seen, returns have been positive across all credit ranges as investors grappled for yields which continue to be seen as a value relative to the broad swathes of international debts now sporting negative yields.


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Source: ICE BofA ML | Past performance is not indicative of future results


While the turnaround in fixed income returns from the selloff in Q4 is impressive and the returns thus far in 2019 compare favorably to equity returns, viewing these through a risk-adjusted basis we clearly see that in the rush for yield, “a rising tide has lifted all boats.” Risk-adjusted returns allow you to compare the returns of an index (or an investment) with that of a risk matched basket of government bonds/swaps with similar risk characteristics. In viewing returns through this risk-adjusted lens, we can see if the level of risk an investor may be taking to generate returns relative to a “riskless” benchmark such as government securities, is commiserate to the return they are receiving. The implication of the Risk Adjusted Returns graphic below is that relative to government securities, returns in some broad fixed income sectors have been neither adequate for the levels of risk nor, as seen below, consistent with history. Understanding these risk considerations is paramount to our continued insistence that investors know what they own.


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Source: ICE BofA ML | Past performance is not indicative of future results


In addition to understanding the role risk-adjusted returns plays in an investors portfolio, it is as critical to decompose fixed income returns into income and price return to clearly understand why time in the market is more important than timing the market. In fact, a quick survey of history will illustrate times when flat to negative risk-adjusted returns on fixed income assets highlight a period of pricing volatility which eventually gets reversed.


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Source: ICE BofA ML | Past performance is not indicative of future results


The chart below presents a relatively short window to highlight the contribution of price and income to fixed income returns. As of August 19, QTD returns in selected broad ICE BofAML Indices are decomposed into the level of total return being generated by price and by income. The contribution of price (light blue) to total return can be clearly seen. In fact, this contribution is consistent with performance of these same indices on a MTD and YTD basis. Clearly, price has contributed to total return more than income for the past year.


Captured in the analysis of both returns decomposition (above and below) and the risk adjusted returns seen earlier is that over the long run, the value of getting and staying invested in the fixed income markets is how returns are captured consistently.


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Source: ICE BofA ML | Past performance is not indicative of future results


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Source: ICE BofA ML | Past performance is not indicative of future results


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Source: ICE BofA ML | Past performance is not indicative of future results


On a 3-, 5- and 10-year basis, the income component of return has accounted for the preponderance of total return in a fixed income portfolio. In fact, during some periods and for some sectors of the markets, the income component of return is the only reason and investor experienced a positive total return.


With interest rates compressed across the globe and expectations that low rates may be here for some time, it is even more critical to capture as much coupon as is risk-appropriate and allow this coupon to work for the investor. While the gnashing of teeth and wringing of hands seen in the media will never end, we believe attempting to beat the market by timing entry and exit points is a fool’s game. In the fixed income markets it is time to get invested and stay invested letting the coupon work for you.


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Source: ICE BofA ML | Past performance is not indicative of future results


As JB Golden impressed up on us in a prior Viewpoints;


“Regardless of your view…we would argue that whatever your stance on the direction of the economy and interest rates moving forward, a plan that includes maximizing cash flows and minimizing cash on the sidelines most likely wins the day. Small tactical shifts in interest rate and credit exposures can certainly be warranted but will almost certainly not trump time in the market.”


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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