Neither rising rates nor rising defaults would spell the end of opportunistic, diversified fixed income.
There is one piece of conventional wisdom you may have heard in recent years. It says that opportunistic fixed income investors have been forced into high yield and emerging market debt because conventional bond yields have been so low, and that “chasing yield” like this always ends badly.
A variation says investors must be crazy to use “risk parity” strategies—in which modest leverage is applied to risk-efficient, bonds-heavy diversified portfolios—when bond yields have to go up.
I think this conventional wisdom is mistaken, but perhaps not for the reasons you assume.
Low Inflation Means Low Asset Correlations
In my role overseeing corporate bond portfolios, I don’t look forward to a turn in the credit cycle, and as a fixed income CIO I’m not the biggest fan of rising interest rates. But as the manager of diversified fixed income portfolios, I don’t need the credit cycle to extend indefinitely, or the Fed never to hike again. All I need is for inflation to stay low. Why? Because low inflation typically means low asset correlations.
Five or six years ago, we conducted some research for a client into how markets behaved through various inflation regimes. We found that one of the major consequences of the persistent low inflation since the late 1990s was a generally negative correlation between risk-free and riskier assets, even during the financial crisis when so many markets were disrupted.
This might seem counterintuitive. For 30 years, long-dated bond yields have fallen and riskier asset prices have risen, which looks like high correlation. One might also assume that a new bout of inflation would be horrible for bonds but pretty good for high yield and equities, as rising prices boost companies’ margins.
An Important Distinction Between Long-Term and Short-Term Correlations
Over the longer-term this is correct. But when it comes to portfolio risk management, it’s the short-term co-movement of asset prices that’s important. With this time horizon, if inflation expectations rise substantially, the underlying boom in the economy doesn’t matter: Bonds would likely get pounded but so would equities, because equities are very long-duration instruments whose cash flows are discounted with long-dated bond yields.
For the moment, what I want to get across is the inflation dynamic behind the diversification that investors can get from adding higher-yielding assets to fixed income portfolios, or leveraging the long-duration, risk-free part of risk-parity portfolios.
As long as inflation remains low, when bond yields edge up the value of riskier assets will tend to rise, too. And if the credit cycle turns over, bond yields should fall. In that context, high yield remains a useful exposure even as the credit cycle gets long in the tooth and Treasuries, Bunds, Gilts and JGBs remain useful despite their meager income. The conventional wisdom misses this point.
The Signs of Inflation Remain Faint
Of course, this may suggest that investors need to look out for higher inflation, rather than rising rates or defaults, as the signal that it’s time to reassess the way portfolios are put together.
That signal remains very faint. Oil is making a bit of a comeback, for sure. But last week Fed officials held rates again and noted the economy had “slowed.” U.S. economic surprise indices have turned negative, the latest estimate for Q1 GDP came in below forecast, at +0.5%, and year-over-year CPI fell from 1.0% to 0.9% in March. Underneath that, April’s manufacturing PMIs and Q1 capital goods orders hit their lowest levels since 2009 last week, and new home sales and the Conference Board’s consumer confidence index both declined. Elsewhere, the first estimate for April CPI in the Eurozone came out last week, falling well below zero again, as it also did in Japan, where the central bank pushed back its 2% inflation target for the fourth time in a year.
As long as this environment persists, we believe the opportunistic fixed income portfolio, the broad diversified portfolio or the risk-parity portfolio remain among the most robust strategies in town.
In Case You Missed It
- U.S. New Home Sales: -1.5% to SAAR of 511,000 units in March.
- U.S. Durable Goods Orders: +0.8% in March (excluding transportation, durable goods orders decreased 0.2%).
- Case-Shiller Home Prices: February home prices increased 0.2% month-over-month and increased 5.4% year-over-year (NSA); +0.7% month-over-month (SA).
- U.S. Consumer Confidence: -1.9 to 94.2 in April.
- Federal Open Market Committee Decision: The FOMC made no changes to its policy stance.
- U.S. 1Q 2016 GDP (first estimate): +0.5% annualized rate.
- U.S. Personal Income and Outlays: Personal spending increased 0.1%, incomes increased 0.4%, and the savings rate increased to 5.4% in March.
What to Watch For
- Monday 5/2: Global Purchasing Manager Indices
- Monday 5/2: ISM Manufacturing Index
- Wednesday 5/4: ISM Non-Manufacturing Index
- Friday 5/6: U.S. Employment Report
– Justin Gaines, Investment Strategy Group
Statistics on the Current State of the Market – as of April 29, 2016
|
Market Index |
WTD |
MTD |
YTD |
|
Equity |
|||
|
S&P 500 Index |
-1.2% |
0.4% |
1.7% |
|
Russell 1000 Index |
-1.2% |
0.5% |
1.7% |
|
Russell 1000 Growth Index |
-1.7% |
-0.9% |
-0.2% |
|
Russell 1000 Value Index |
-0.7% |
2.1% |
3.8% |
|
Russell 2000 Index |
-1.4% |
1.6% |
0.0% |
|
MSCI World Index |
-0.8% |
1.6% |
1.4% |
|
MSCI EAFE Index |
-0.4% |
3.0% |
0.0% |
|
MSCI Emerging Markets Index |
-0.6% |
0.6% |
6.4% |
|
STOXX Europe 600 |
0.1% |
2.3% |
-0.4% |
|
FTSE 100 Index |
-1.0% |
1.4% |
1.5% |
|
TOPIX |
-4.8% |
-0.5% |
-12.5% |
|
CSI 300 Index |
-0.5% |
-1.8% |
-15.3% |
|
Cash & Fixed Income |
|||
|
Citigroup 2-Year Treasury Index |
0.1% |
0.0% |
0.8% |
|
Citigroup 10-Year Treasury Index |
0.7% |
-0.2% |
4.6% |
|
Barclays Municipal Bond Index |
0.2% |
0.7% |
2.4% |
|
Barclays US Aggregate Index |
0.4% |
0.4% |
3.4% |
|
Barclays Global Aggregate Index |
1.5% |
1.3% |
7.3% |
|
S&P/LSTA U.S. Leveraged Loan 100 Index |
0.4% |
2.3% |
4.9% |
|
BofA Merrill Lynch U.S. High Yield Index |
0.8% |
4.0% |
7.3% |
|
BofA Merrill Lynch Global High Yield Index |
1.0% |
3.6% |
7.6% |
|
JP Morgan EMBI Global Diversified Index |
0.3% |
1.8% |
6.9% |
|
JP Morgan GBI-EM Global Diversified Index |
1.7% |
2.6% |
13.9% |
|
U.S. Dollar per British Pounds |
1.6% |
1.9% |
-0.6% |
|
U.S. Dollar per Euro |
1.9% |
0.5% |
5.4% |
|
U.S. Dollar per Japanese Yen |
4.2% |
5.0% |
12.4% |
|
Real & Alternative Assets |
|||
|
Alerian MLP Index |
0.3% |
11.0% |
6.4% |
|
FTSE EPRA/NAREIT North America Index |
0.0% |
-2.2% |
3.9% |
|
FTSE EPRA/NAREIT Global Index |
0.6% |
0.1% |
5.2% |
|
Bloomberg Commodity Index |
3.0% |
8.5% |
9.0% |
|
Gold (NYM $/ozt) Continuous Future |
4.9% |
4.4% |
21.7% |
|
Crude Oil (NYM $/bbl) Continuous Future |
5.0% |
19.8% |
24.0% |
Source: Factset, Neuberger Berman LLC.
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