By Justin Pawl, CFA, CAIA, CFP®
In this week’s edition:
- Last Week Today. Events influencing markets.
- Fixed (no)Income II. How to address low interest rates in investment portfolios. Part I is available here.
Last Week Today. The October retail sales report was weaker than anticipated, showing only a 0.3% increase (vs. 0.6% consensus) and September sales were revised down by 0.3%. | Single family home starts jumped 6.4% in October (29.4% year-over-year) to the highest level since April 2007, adding 0.2% to estimated 4Q GDP. | Existing home sales in October rose 4.3% to the best level since November 2005, and the average days on market fell to 21 from 36 days last year. | Treasury Secretary Mnuchin moved to end most of the Fed’s special pandemic lending facilities on Dec. 31 and asked the Fed to return $455 billion in unused CARES Act funds. The action may be designed to put pressure on Congress to pass another stimulus bill. Perhaps, but although most of the funds had not been spent, one reason for the quick recovery in credit markets earlier this year was that investors knew the Fed had ample firepower to quickly provide liquidity backstops if necessary. With rising COVID cases threatening economic activity and widespread vaccinations several months away, this is a risky time to remove any weapons from the Fed’s arsenal.
Click on the table below for a summary of asset class weekly, MTD, and YTD performance.
Fixed (no)Income II – A Path Forward. To resolve the thorny allocation issue of negative real yields and low interest rate starting points, investors should first consider what they can realistically expect from traditional fixed-income investments going forward. Investors must then determine how to build a portfolio allocation that meets their long-term financial goals while balancing the risk of large stock market declines. And, investors must do all of this in the context of current market conditions where government bond fixed-income allocations can no longer provide suitable yield and suitable downside protection simultaneously.
Because of this paradox, investors should view the role of fixed income differently than they have historically. Today the yield on the Barclays Aggregate Bond Index, a benchmark for debt in the U.S., is only 1.2% annually. Many don’t recognize that the Barclays Agg is not a riskless investment like government bonds. Treasury bonds comprise only about 50% of the Barclays Agg. The rest of the benchmark consists of Corporate and Securitized debt, introducing significant credit risk into the benchmark and strategies that track it. During the Pandemic drawdown, the credit risk showed up when the Barclays Agg declined -2.6% in mid-March, contributing to equity losses in a portfolio rather than offsetting them. And even with the additional credit risk, the yield is below the current rate of inflation.
Rather than view fixed income as a catch-all solution for risk management and income generation, investors need to define which role they will prioritize and then look to non-traditional sources to fulfill the other role.
- Prioritizing Yield: Investors wishing to maximize yield from their fixed income allocation will be forced to take on more credit risk. There’s simply no other way in today’s market environment. Whether that credit risk comes in the form of publicly-traded investment-grade corporate debt, high yield debt (aka, “junk bonds”), or private lending sources, in a significant market downturn, investors should not expect the holdings to rise in value. Instead, the investments’ value will likely decline (hopefully to a lesser degree than equities), leaving portfolios susceptible to higher volatility.
- Prioritizing Protection: Mathematically, in the absence of negative interest rates, investors cannot count on government bonds to offer a lot of downside protection. From today’s starting point, if the 10-year bond went to zero instantaneously, it would rise in value by about 6%; if rates fell to zero over a 12-month timeframe, the gain would be closer to 5%. There’s just not that much juice left in 10-year bonds given today’s starting yields. Investors could move further out the yield curve and invest in 30-year bonds, which would offer more downside protection (and slightly better yields). Still, in doing so, they are taking on significant interest rate risk that will result in capital losses if interest rates rise. Investing in riskless U.S. government bonds presents a significant opportunity cost (negative real yields) paired with the asymmetric risk that interest rates can increase a lot more than they can fall.
Expanding Your Investment Toolkit
For investors that want to increase the yield in their investment portfolios and simultaneously increase protection, there is a path forward. However, this path requires that investors rely on credit-oriented strategies for yield and “long volatility” strategies for protection. Long volatility strategies tend to perform best when markets are in disarray, and financial risk is high.
Definitionally, “long vol” can be thought of as strategies that tend to perform well when the volatility of instruments they trade rise. A simple representation of volatility is the VIX, an index that measures the market’s expectation for 30-day forward-looking volatility (i.e., the magnitude of directional changes) of the S&P 500. When the VIX Index is rising, equities are typically declining (and vice-versa). Sharp moves in equity markets generally result in pronounced VIX movements. For example, in the first quarter of this year, when equities declined by more than 30%, the VIX Index rose by more than 300%. The table below expands on the previous “Bear Market” performance table to include the change in the VIX Index during each of the six market declines.
While the VIX Index itself is uninvestable, there are strategies that trade derivatives on the VIX Index. These long volatility strategies come in various types, and it’s beyond the scope of this memorandum to discuss each of them. Of course, as with all investments, there is no guarantee that any specific long volatility strategy will perform well just because equity markets are declining. That is to say, long volatility strategies are not an insurance policy. But isn’t it better to allocate a portion of your portfolio to an investment that at least has a chance at adequately protecting your portfolio when markets fall, rather than rely on the paltry potential performance from bonds (which are also not guaranteed to rise in price during periods of equity market dislocations)?
Covenant is well-versed in in both long volatility and income-oriented credit strategies, and for those interested, we can discuss the pros and cons of adding these “non-traditional” strategies to your portfolio. While your portfolio may move differently that you’re accustomed to, integrating long volatility strategies with non-traditional fixed income, can improve the overall returns of a portfolio when compared to following traditional portfolio allocations with interest rates near historic lows.
The investment path ahead promises to be challenging, but there are tools available to make it less so.