When interest rates rise, bond investors experience market losses. Although benchmarks are very effective in giving investors a way to monitor changing performance, many times, they fall out of sync with the financial system’s evolution. This is poignant as many plans still have fixed-income allocation return assumptions over 5%. However, historically low interest rates over the past few years orchestrated by the Federal Open Market Committee (FOMC) utilizing quantitative easing have basically negated real rates of return for this asset class. The longest bull market in bond prices is over and this will prompt principal losses as rates rise.
Clearbrook has modified how it views fixed income and adjusts how risk is evaluated and instituted with the approval of our clients’ investment committees.
Be Careful About Stripping Fixed Income to the Bone
Many other managers have increased their risk by investing heavily in ill-liquid and higher-risk options. The thesis is combining market risk, credit risk, and structure risk to determine the relative value of an investment overlaid on the investment guidelines. Some managers have also drifted into products with specific structures that overpower the investments. These products, such as private equity, private credit, or hedge funds which have lockups and/or gates, can provide enhanced returns but expose portfolios to different restrictions and risks.
The Evolution of the Traditional Debt and Bond Holders
After the various financial dislocations stemming from 2007, some forward-thinking investors realized that banks could no longer monopolize the lending markets, and there was the opportunity to compete with banks. The most lucrative being the middle market lending area as well as the migration towards larger loans. What they found was that if you worked as an ally with the lender, your odds of success greatly improved. If you are a loan (bond) investor, you have fewer issues and challenges of delayed coupons and modified capital allocation, which has proved to be a very successful long-term strategy versus using finite “drop dead” dates.
Two of the most significant practical differences between traditional debt and a proactive bondholder are the ability to protect yourself from rising rates and to mutually align with the company to use the funds and other derivative tools to work with the company, not against them. This usually allows for higher yields which also immunizes price declines from higher rates.
Timing of Fixed-Income Investments During Gradually Rising Rates
Clearbrook is very pleased with their allocation and selection in many of the discretionary accounts regarding fixed income. Even though rates have declined in the past few months, that trend is probably not going to continue as the ten-year moves to 1.75%. The FOMC has said they will begin tapering next year and will probably let the investors push up yields and then support them by buying fewer bonds and modifying reserve requirements by banks. We help our clients determine a reasonable time frame to take some price risk toward returns that are more likely to be less than or equal to the extra investment income earned by new ideas.
For example, if you put $1 into a floating rate, lower-grade bond fund that is earning four percent and keep $1 in cash, you have now increased to a $2 earning at two percent. The longer there is no price deterioration on the bond fund, the better the metric. We have structured some accounts to hold cash as a specific asset allocation offset by two or three different higher-risk strategies.
How Do We Calculate Additional Risk?
As we mentioned earlier, fixed income looks at market, credit, and structural risk. The greater the spread of the product to government rates, the less sensitivity. The shorter the duration of the assets, the less market risk. The manner of leverage using a floating rate debt reduces the market risk. The aspect of credit risk is the variable, which usually equates to how much time a company has to cure the problem and who holds the loan. Traditional loans provide a paradigm where default favors no one, but bondholders can be rewarded by cooperation.
From a consulting standpoint, portfolio trading and management depend on finding the right managers and giving them the time to do their job. This strategy’s closest comparison is pruning a bonsai tree versus whacking away at a hedge with an electric trimmer!
Ready to Re-evaluate Fixed Income Allocation?
Expected returns for typical fixed income portfolios have been lower for the last few years, but we see new prospects for economic growth, driven mainly by the distribution of COVID-19 vaccines, pushing bond yields higher. Long-term fixed-income investing can make a big difference in our clients’ portfolios. We also believe that when rates do indeed rise, the increase will be measured and not drastic.
Upward trends in interest rates and a steepening yield curve can compensate investors who take on duration risk with longer-term bonds offering higher interest rates. Ultimately, a diversified portfolio containing both stocks and bonds balances the relationship between the two asset classes regardless of the prospects for future returns. Fixed income is a safe way to continue strong capital inflows during periods of market stress despite rising rates. In equity market downturns, bonds have historically mitigated portfolio volatility over time. In fact, investors who reduce investment duration to avoid market losses in a rising rate environment may sacrifice the benefits of fixed income investing.
Don’t become too focused on the temporary losses exhibited by bonds because of recent moves in interest rates. As interest rates increase, so do the expected long-term returns. Clearbrook offers the perspective needed to assess how market changes alter the balance of risk and return within a diversified portfolio.
Sources:
Wealthspire Advisors, Fixed Income Investing in a Rising Rate Environment 2021. https://www.wealthspire.com/blog/fixed-income-investing-rising-rate-environment/