You don’t need me to tell you we’re in a bear market here. Those are fairly common. The slightly more unique feature of this one is that bonds are also in a bear market alongside equities. Is that a surprise? Not sure, it’s been predicted every year since about 2012 so in some ways it’s a decade late arriving. Is it a catastrophe? No, not really – no-one promised that bonds always do the opposite to stocks (that’s not quite what diversification means), and anyway, the lower bond prices go the higher their future returns…. so, are bonds, in fact, back?
Here’s how a range of popular bond funds/inidices are doing this year: the story is the the same across corporate bonds, gilts, US treasuries and index-linked bonds.
After a decade of “yield famine” on the bonds front with huge swathes of the market at mind bogglingly low – even negative – yields. it could be that we’re seeing a sharp return to the more normal world where bonds do give investors steady postive real returns (The Credit Suisse Yearbook shows bond real returns of c2% globally over the last century, but yields more recently haven’t been compatible with this in the future).
The chart below shows how the total yield on US corporate bonds is now at a 10-year high close to 5%, having been sub-2% until fairly recently. It’s a similar pattern in high yield bonds, European bonds and emerging markets.
Another key parameter to watch out for here is the stock/bond correlation. Over the last 10 years we’ve got used to this being negative – so that bonds more often than not move in the opposite way to stocks – and that’s great for your balanced portfolio. But as AQR show in their recent piece “The Golden Parameter” this wasn’t always the case and maybe won’t always be the case [AQR piece].
So if bonds markets are having a bit of a turning point moment here, how do we think about bond portfolios in a world of higher inflation, higher returns and lower diversification?
Not all bonds are created equal. Yeah … duh. It’s something that’s kinda obvious really, but often gets sort of semi-forgotten and it really matters for constructing sensible investment portfolios, especially at the low to medium risk segment and for retirees.
The Bottom Line:
Most investors are bond investors, although they don’t often spend too long thinking about it. Whether through balanced funds, “lifestyle” derisking as you get older or in lower risk funds for those at or around retirement.
Unlike stocks, bond indices probably aren’t great investments. How do I know? Because the vast majority of active managers easily beat them. So what? As an investor don’t pay an active manager to do the easy work in constructing a better portfolio: do it yourself. Think: duration, liquidity, fees, growth.
Background on bonds –
Bond markets are heavily influenced by certain categories of investor that have particular preferences (eg for liability matching), this pushes bond markets away from a clean risk/return frontier.
Market capitalisation weighting, an imperfect but still pretty decent starting point for capital allocation in equity markets is pretty much absent in bond markets where the biggest issuers form the bigger part of most indices which is not the same thing. By using a passive equity index you are freeriding on the capital allocation decisions of all active market participants which turns out to be a pretty good thing. In bonds you’re just lending to the issuers that want to borrow the most.
When almost all active managers can beat the index, the index probably isn’t an efficient asset, so you can do better.
Bonds as a small part of a balanced portfolio is different to bonds as a big part of a low-risk portfolio and this isn’t given enough thought.
You need to think through in more detail questions like maturity, liquidity, fees and separate growth credit.
To put into context where we are in bond market declines this chart is pretty good.The Barclays Global Agg index (which covers 28,000 bonds and a cool 60 TRILLION of assets) is off to its worst start to a year in half a century (chart from Bianco research).
So, there’s pain in the bond markets, but it isn’t evenly distributed. Floating rate and low duration assets are doing kind of fine, but long duration government bonds have gone down as much as tech stocks.
Here’s the fixed income “quilt” from JP Morgan’s latest guide to the markets
It’s pretty obvious though that the assets shown in the diagram, spanning from short term lending to “junk” rated companies, emerging market debt in local currency and treasury bonds are not all the same thing. Doesn’t really make sense for them all to sit in the same asset class from an investment perspective.
I think too much capital in bond markets is lazily directed into broad market funds which don’t serve the end investor that well, because of the power of the indices, and because that’s what fund managers serve up. But it needn’t, and shouldn’t be like that. It’s often the equity part of the classic 60/40 portfolio that gets most focus, but actually these days it’s the bond piece that you want to pay more attention to especially in a world of higher inflation.
I reckon the industry is fundamentally not set up to deliver properly for investors in a higer inflation world and I wrote about this a little more here). Funds designed heavily around bond indices are a large part of the issue.
This really matters because popular target date funds from Vanguard feature substantial allocations to bonds and the allocations grow over time, and some very popular workplace pension providers (like Nest in the UK which manages money for over 10 million British workers) have good sized allocations to bonds even at young ages. This matters for individual investors and it matters for institutions too.
Can we do better with bonds?
A neat piece of work from PGIM starts to unpack one of the big issues with bond investing – you can’t assume that bonds all sit on an efficient frontier where you generally get paid more for taking more risk. It’s just not empirically true, and there’s a good reason for that: many bond market participants like insurers and pension funds have a preference for long-dated bonds (which are riskier in the eyes of your “normal” investor), central banks have also been big players in bond markets and their preferences are also different).
The PGIM data shows that longer dated bonds tend to be a “worse” investment (less return for more risk) than shorter dated bonds.
Now let’s look at how active bond managers do against their indices (again via PGIM). WOW! These bond managers look like a pretty special breed HOW CAN THE REST OF US MORTALS GAIN SOME OF THIS AMAZING SKILL AND INSIGHT?
Or … maybe the indices are easy to beat?
What’s going on is that the indices are often a mongrel/mashup of a sorgasborg of different maturies and quality bonds (sorry for the technical terms), corporate and government, weighted in ways that are driven by the amount of debt being issued, and the technicalities of index inclusion rules: not really very thoughtful ways to allocate capital, which then present an easy bogey for your active managers.
The issue is that indices generally play a huge role in capital allocation, but while in equity markets you can argue with good justification – efficient markets- this is a decent starting point, in bond markets, not so much.
So here’s a good reason to actually start paying more attention to the bond part of the portfolio and how it’s constructed – not necessarily an argument for more active management mind, you can still do things in a passive or semi-passive way in a lot of places, but you need to be a little more thoughtful.
Five things to think about:
- Duration. You get duration in your portfolio when you own long dated bonds (either government or corporate). In many ways it’s been a great risk premium over the years often moving in the opposite direction to equity so it may be something you want in a mixed portfolio, but you don’t always get compensated the same for it.
One issue is that common corporate bond indices will pick up some duration as standard which you might not want. It means that those bonds will generally have worse risk/return profiles (as per the PGIM data above).
If you are mixing a little bit of bonds into an equity-heavy portfolio you might be ok with being heavy on duration as it offers a bit of diversification/tail-risk hedging, but if bonds are going to be the principal driver of your portfolio (eg a low risk fund or for a retiree) then the balance shifts and you need stuff in there that will pay its way. This points you more toward shorter dated corporate bonds where you can earn a little interest without the big price swings you get with duration. Floating rate bonds are also something to think more about in this context. You’ll also want to think about a global (developed market) opportunity set, not just focusing in on a home market like the UK. You’ll get better opportunities and more diversification through the cycle with US, European and UK bonds (hedging any overseas exposures back to home currency).
2. Liquidity. The nature of bond markets means that you don’t get the clean break between listed and unlisted securities like you do in equities. It’s much more of a spectrum. A less liquid bond isn’t necessarily always riskier than a liquid one, and the same goes for complexity as well. A good example here is Asset Backed Securities (“ABS”).
Yes, I know, a lot of folk will run a mile at the mention of ABS – “isn’t that stuff what caused the financial crisis?”. But it’s different, it’s evolved and European ABS was never like that anyway. Besides, the fact that so many investors naively dismiss it is exactly why you can earn a decent amount of extra yield for roughly the same kind of risk as you take in listed corporate bonds.
3. Think about inflation linkage. Looking at the returns for inflation-linked gilts (government bonds) this year investors could be forgiven for being a little perplexed. In the face of the highest inflation we’ve had for decades inflation linked gilt funds have … actually lost money. A lot of money, more than 20%. The equivalent in the US (TIPS) have also lost money – not most investors idea of inflation protection or inflation linkage.
The reasons for this are a little complicated and show what a complex asset an inflation-linked bond actually is, but a lot of it is related to the duration point above – these bonds also come with a tonne of duration attached which has not been a good investment this year, but might be a good thing to have in the portfolio overall. No easy answers but this year shows you need to be thoughtful with the role of inflation-linked bonds especially if in a bond-heavy portfolio as opposed to a hedge in an equity dominated portfolio.
4. Fees. In a world of (still) relatively low yields fees matter a lot. That’s certainly one positive of an index-driven solution, you can broadly access those markets for a cost that doesn’t eat into returns. There are plenty of situations where investors identify a potential additional risk premium somewhere and then turn round and pay most or all of it away to an active fund manager. Don’t do that! That’s why we do need slightly better structured indices and semi-passive products to base portfolios on. There’s a need for more global, short-dated passive-ish corporate bond portfolios to be available – the going rate for fees on these ought to be circa 0.1% per year. Some do exist but they aren’t as popular or as available as they ought to be – lots of capital still flows into UK-only boad market corporate bonds.
5. Growth. In this piece I’m mainly thinking of your lower risk, stable bond allocations. It’s clear that there’s a separate asset class entirely of growth credit which also deserves a separate look and consists of high yield bonds, loans plus emerging market debt. This is different enough to warrant being looked at separately.
Bringing these ideas together we can envision bond portfolios built along the three pillars of: government bonds, short-dated passive corporate bonds, asset-backed securities. Quite a departure from what you get with an allocation to a conventional “all stocks” index (less duration, more spread), but not necessarily a lot more expensive in terms of fees. It would have helped this year and it’ll help in the future.
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