Investors are currently facing unprecedented conditions in fixed-income. Yields are historically low and even negative in some cases outside the United States. In some segments, investors are taking on elevated levels of interest rate risk as well. The combination of abundant liquidity and accommodative monetary policy has encouraged investors to move toward riskier assets and push asset valuations higher.
At current levels, we are cautious. We think investors can benefit from a flexible and nimble investment mandate that can invest across a wide range of strategies and sectors, including less traditional parts of the market.
Core Bonds: Low Yields and Long Duration
Core bonds have historically served as portfolio “ballast” during equity market declines. We think they will continue to serve this purpose, but the benefit will be subdued given today’s low starting yields. Investors are taking on historically high levels of rate risk.
The duration of the aggregate bond index has almost never been higher at over six years, while yields are near all-time lows. This is a dangerous combination. Historically, you could have expected annual income generation to offset a 100-basis-point short-term increase in rates. Now with yields around 2%, a yield increase of just 30 basis points would wipe out a year of income.
Longer term, starting yields in the broad investment-grade index are highly correlated with five-year total returns. At 2%, five-year total returns will be around that level. A return that low is in line with the Federal Reserve’s current inflation target, and certainly does not meet the return needs of most clients.
DoubleLine’s Jeffrey Gundlach and others have pointed out that falling and often negative global yields are one of the factors pulling U.S. yields down. Foreign investors are being forced to invest in the United States. However, the cost to hedge U.S. bond investments into their own currencies is now prohibitively expensive, so they are increasingly investing unhedged. Should the U.S. dollar decline, hitting returns for unhedged foreign investors, the pursuant outflows could reverse some of the demand dynamics that have supported U.S. fixed-income markets.
In a year like 2019, when yields fall even further and core bonds register nearly double-digit returns, interest rate risk may not be top of mind for investors. Fear seems focused around recession risk and not the possibility of a cyclical upturn. But when clients invest in core bonds, they often think “safe.” We don’t believe many investors fully understand the potential short-term downside present in investment-grade sectors. Should global growth pick up and rates rise sharply, they could be in for a rude awakening.
High-Yield Bonds: No Room for Error
High-yield bonds performed extremely well in 2019 gaining 14.4%. As Guggenheim Investments’ fixed-income team and other managers we invest with have pointed out, spreads over U.S. Treasuries are nearer to cycle lows than cycle highs (let alone the highs seen in extreme recessionary environments). We believe the upside is limited with asymmetric downside. See the chart to the left below, which illustrates the historical spreads relative to 10-year Treasuries, including where we are now.
As the chart on the right above shows, within high-yield, the effective yields on higher-quality BB-rated junk bonds are even less attractive (at 3.7%). This higher-quality segment has starkly outperformed lower-quality ones recently. But that also means valuations are likely less attractive there now. A large percentage of the high-yield market trades at or above call price. For many issues, yields will only move materially lower if bonds are refinanced at a lower level. Investors have pulled returns forward and now face negative convexity.
There are also concerning developments on the business fundamentals side of the equation. Credit downgrades are starting to outnumber upgrades. On a recent conference call, portfolio managers at FPA said leverage metrics are as poor as they’ve ever been outside of a recession. Debt-to-EBITDA is at an all-time high, double what it was before the 2008 financial crisis. And interest coverage ratios are low despite all-time low debt costs, and they are starting to turn down. One of the hedge funds we follow wrote in their year-end letter that more and more distressed investors are stepping away from the credit market. Couple all this with drastically lower dealer inventory and you could potentially see things spiral dangerously in a selloff due to the lack of liquidity and natural buyers.
While we are not calling for an imminent decline in high-yield bonds, we are cautious on valuations, fundamentals, and liquidity. Our view that high-yield can generate mid-single-digit returns this year is predicated upon a very narrow Goldilocks scenario in which the Fed keeps rates low or even cuts further to extend the cycle, while avoiding both recession and strong reflation. In a recessionary market, high-yield prices will decline as default risk rises. And in a sustained cyclical rebound, high-yield would face a headwind, assuming the Fed raises rates. We have not eliminated credit risk in client portfolios; we think there are attractive ways to gain exposure to credit in a prudent manner, often in off-benchmark securities.
Where Else Can Investors Find Yield?
A key question today is how to generate higher income for clients without taking on too much credit or duration risk.
In core bonds, we have in recent years invested with active managers with lower-duration and a quality bias. When rates collapse like in 2019, these managers failed to keep pace with the longer-duration benchmark. But over a full credit cycle, they have historically beaten the index through security selection. And they’ve done so with less volatility.
Overall, though, Litman Gregory has been recommending that advisors should allocate part of their clients’ core bond exposure to flexible income strategies and specific higher-quality, liquid segments of the credit markets.
- We have invested in and recommend several distinctive, actively managed flexible income strategies, run by experienced portfolio managers. In most cases, we’ve known these managers for many years, sometimes decades. We have completed intensive due diligence on their strategies and firms. They have relatively unconstrained mandates and possess the flexibility to take on higher credit risk, invest in floating-rate versus fixed-rate securities, or even hold cash if opportunities are scarce.
- Finally, in the below-investment-grade market, we hold modest allocations to floating-rate loans, which we prefer over high-yield bonds based on return, safety, and duration considerations. Loans currently have higher yields and trade at lower prices than high-yield bonds. With loan prices generally below par, capital appreciation potential is not as constrained as it is for high-yield bonds. Loans’ seniority in the capital structure has historically led to higher recovery rates in the event of a default. Plus, unlike high-yield bonds, loans have minimal interest rate risk since their coupons adjust upward when rates rise.
- For our private clients, we also invest in even less traditional areas that investors rarely have exposure to, such as put-selling option income and diversified equity income strategies.
We have been willing this cycle to accept some additional credit risk in exchange for higher long-term returns and less interest rate risk. Since December 2008, our bond allocations have outperformed the aggregate bond index. And despite higher equity sensitivity, their volatility and max drawdown have been lower than the index’s. We continue to believe the added credit risk of our non-traditional holdings and floating-rate loan allocation is more than offset by these holdings’ higher return potential and/or the protection they provide against rising rates.
—Litman Gregory Investment Team