While we like the protection that traditional investment-grade bonds provide, their yields have been paltry for years. Our return expectations for the asset class have been in the low single digits under a wide range of economic and interest rate scenarios. Our analysis also indicated that if interest rates were to rise sharply, traditional bonds would be susceptible to potentially large short-term downside, which many investors are not prepared for. So in the years following the financial crisis, we began moving away from core bonds into flexible income strategies run by active managers. We later added an allocation to floating-rate loans.
- The flexible income strategies we selected are distinctive, actively managed strategies with a history of success, run by experienced portfolio managers. Generally, they have 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. For our private clients, we also use a multi-strategy alternative income fund.
- The actively managed floating-rate loan funds we own should generate returns that are comparable to the passive leveraged loan options over a full credit cycle, despite being more conservatively positioned. Floating-rate loans are attractive to us because of their higher yields compared to traditional bonds, and their coupons adjust upward with rising rates resulting in next-to-no interest rate risk. We also currently believe that loans are more attractive than high-yield bonds due to lower valuations, structural advantages, and the potential for price appreciation.
The motivation behind this move away from traditional bonds was to lower our exposure to rising interest rates, while also increasing returns in most plausible economic/market scenarios. The tradeoff is that we took on increased credit risk. But by combining traditional bond funds with more credit-oriented strategies—each exposed to a different, uncorrelated primary risk—we believe we built a superior fixed-income allocation. In 2019, we added exposure to 7- to 10-year Treasuries in place of some of our investment-grade core bonds, which should (and has) enhanced the diversification in our overall allocation.
Our positive view of the prospective performance of our bond portfolios is reinforced by the fact that they have an overall higher yield and lower duration than our benchmark (the Vanguard Total Bond Market Index).
Performance & Risk Since 2008
Let’s look at the results. Since we initiated our move away from traditional bonds in December 2008, our fixed-income portfolios have far and away outperformed the traditional bond market index fund, with very similar volatility. Clearly, “safer” traditional bonds are not without risk, they are simply exposed to a different risk—interest rate risk.
At the start of 2016, credit-oriented bonds fell along with equity indexes, but the impact on our portfolios was muted. Later in the fall of that year, traditional bonds suffered a drawdown of their own on expectations of a pro-growth Trump presidency (and higher rates), during which our non-traditional bond holdings performed well.
In 2018, we saw periods when both stocks and bonds declined at the same time. Then stocks experienced one of their worst fourth quarters in history. Despite higher credit exposure, our fixed-income allocation still effectively matched the core bond index for the year.
When the pandemic hit in 2020, credit markets experienced conditions and price declines not seen since the 2008 financial crisis. Even the Treasury market, usually one of the most liquid areas, froze up at one point. Several of our managers have told us at times it was impossible to transact in the market, even to buy or sell government bonds. As one should expect, our credit strategies suffered steep mark-to-market declines in this period, but even the core bond index was down 10% at one point—unheard of volatility. In the end, the Federal Reserve came to the rescue, massive monetary support and fiscal stimulus followed, and before year-end, our portfolios had recovered fully from their drawdown. Our portfolios have outperformed during the recovery since, while core bonds have been relatively flat.
|Annualized Return||Cumulative Return||Std. Dev.||Drawdown||Upside/
|Sharpe Ratio||Equity Correlation||Equity Beta|
|Litman Gregory Fixed-Income Allocation*||6.02%||102.74%||3.39%||-4.46%||97.8%/27.2%||1.58||0.58||0.13|
|Source: Litman Gregory Analytics, Morningstar Direct. Data 12/1/08 through 12/31/20. *Litman Gregory Fixed-Income Allocation is a proxy of the active bond allocation Litman Gregory AdvisorIntelligence recommended over this period. Traditional Bonds is the Vanguard Total Bond Market Index (VBMFX). Standard deviation is annualized. Max drawdown is based on monthly returns. Rebalanced annually and on trade dates.|
From the table of metrics above, one can see from the positive equity correlation that we’ve been willing to accept some additional credit risk in exchange for higher long-term returns and less interest rate sensitivity. Still, the equity beta of our bond portfolios has only been 0.13, implying that if relationships hold, their downside during equity selloffs should be a fraction of what stocks experience. The higher return we’ve generated has more than compensated for the modestly higher volatility and larger drawdown; our bond allocation’s Sharpe ratio is materially higher.
We continue to believe the added credit risk of our non-traditional holdings is more than offset by the protection they provide against the prospect of rising interest rates, which is only more acute a problem today with core bond and Treasury yields not far above their historical lows. It’s telling that despite the higher credit risk, our bond allocation has captured almost all of the core bond fund’s upside, while avoiding the vast majority of the downside.
The Value of An Outsourced Research Resource
The insight and conviction to execute these portfolio decisions derived from the intersection of Litman Gregory’s asset class analysis and manager research capabilities. Our work on expected returns—both long-term returns and 12-month downside—and the various stress tests we run identified the risk of rising rates, while our due diligence experience in selecting successful managers allowed us to take advantage of the opportunity presented by more flexible strategies and floating-rate loans.
—Eric Russell Figueroa, CFP®, and Jack Chee