Bonds May Not Be Loved,
But They Shouldn't Be Forgotten

January 10, 2018  | by Roman Moravec, James Meisner, Vincent Kravec

Asset Allocation | Fixed Income | Investment Strategy

Summary

  • Today, there is a good deal of hand wringing over the risk of rising rates.
  • While rising long-term rates could be a headwind for core fixed income, as long as rates rise fairly modestly the impact should not be too great.
  • The most likely scenarios support a modest underweight to core fixed income in policy portfolios.

 

When You Need Fixed Income the Most

Most institutional portfolios have strategic allocations to core (investment grade) fixed income, and for good reasons. Core fixed income can serve as an anchor during times when risk assets such as equities and lower grade credit are under assault. The two most extreme such periods in recent history were the tech crisis (2000-2002) and the financial crisis (2007-2009). Using the Bloomberg Barclays U.S. Aggregate Bond Index (“Barclays Agg”) as our proxy for core fixed income, the historical total return charts in Exhibits 1 and 2 show how core fixed income acted as a safe haven during these periods of market turmoil.

EXHIBIT 1
CH1-TechCrisis

EXHIBIT 2
CH2-FinancialCrisisToday, however, there is a good deal of hand wringing over the risk of rising rates. After all, the U.S. Federal Reserve is in the process of normalizing rates, hiking the Fed Funds target from emergency levels around zero at the end of 2015, to the current midpoint target of 1.375 percent as of the last hike on December 19, and possibly hiking as much as 25 basis points per quarter in 2018. At the same time, the Fed has started the process of reducing the size of its balance sheet, starting at a target pace of $10 billion per month in the fourth quarter of 2017, and increasing the pace each quarter by $10 billion per month before peaking at $50 billion per month in the last quarter of 2018. Expectations are that the Fed will continue this process until the balance sheet shrinks by about $2 trillion from the current level of about $4.5 trillion. It should be noted, however, that the balance sheet actually only declined by $7 billion in the fourth quarter, considerably short of the $30 billion targeted reduction.

 

A Flattening Yield Curve (for now)

Hikes in the Fed Funds target have totaled 125 basis points since December 2015, with four of the five hikes occurring since December 2016. This primarily has impacted the front end of the yield curve. Over the course of 2017, the two year Treasury yield moved up by 70 basis points (from 1.19 percent to 1.88 percent) while the 10 year yield actually fell slightly, from 2.44 percent to 2.41 percent. The long end was held in check by a number of factors, including low rates in Europe and Japan and benign inflation in the United States. However, there is concern that the combination of continued rate hikes and a significant reduction of the Fed’s balance sheet could begin to have a negative impact on the long end.

How concerned should we be about this? While rising long-term rates could be a headwind for core fixed income, as long as rates rise fairly modestly the impact should not be too great. Taking a longer term view, the current yield of the Barclays Agg has historically been a good predictor of the future five year total annualized return, as shown in Exhibit 3. Given that the index today has a yield of 2.75 percent, it’s a reasonable bet that the annualized return over the next five years should be about 2.75 percent.

EXHIBIT 3
CH3-ForwardYield_2016 Web Chart_2016 Web Chart

 

The Impact of a More Aggressive Fed

A fairly negative view for rates in 2018 would be four quarterly hikes in the Fed Funds target of 25 basis points each, and a parallel shift higher in the entire yield curve, taking the benchmark index yield from 2.75 percent to 3.75 percent. The approximate six year duration of the index would lead to a principal loss of about six percent, offset by income of about 3.25 percent, for a negative total return of 2.75 percent. However, keep in mind that about 75 percent of active core fixed income managers typically outperform the index.

This scenario would take the Fed Funds midpoint target to 2.375 percent by the end of 2018, higher than the current pace of inflation (roughly two percent) but perhaps about the same as the future pace of inflation should the economy remain strong. A Fed Funds target which is at or slightly above the perceived level of inflation is considered to be a neutral monetary policy and it seems reasonable the Fed could temper or maybe even end the hiking of interest rates at that point, assuming that inflation remains subdued and the economy does not overheat.

Exhibit 4 shows the returns that are associated with this scenario. The Barclays Agg suffers in the first year while rates are rising, but gradually recovers its losses over the next four years, achieving a 2.44 percent annualized return over the five year period. That’s not too far off the initial yield of 2.75 percent, consistent with the historical relationship shown in Exhibit 3. The money market fund yield is assumed to be 1.25 percent in Q1-18, rising to 2.25 percent in Q1-19, then remaining steady for the next four years, with a constant par value.

EXHIBIT 4
CH4-CumRetBarclaysMMF

While this scenario for rates may be fairly aggressive in the first year, it assumes that rates remain steady in the following four years. If inflation remains subdued, the 3.75 percent yield assumed for the Barclays Agg (or about 3.5 percent for the 10 year Treasury note) by the end of 2018 would look quite attractive to many market participants. Keep in mind that the Fed has signaled only three hikes for 2018 and the long end was very well anchored in 2017, so the actual outcome could be better than this scenario suggests.

 

Considerations for Policy Allocations

With the recent strength of equity markets, modest return expectations for core bonds and the prospect of higher interest rates, it is perhaps not surprising that fixed income allocations get little attention in investment committee discussions. But while bonds may not be loved, they should not be forgotten. In our view, the most likely interest rate scenarios support a modest underweight to core fixed income in policy portfolios. This recognizes the risk of rising rates in the near term but also the long term benefit to the overall portfolio due to the favorable correlation properties of fixed income during stress periods in the market and the need for an anchor in the portfolio during turbulent times.

Authors

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Vincent Kravec is a member of the Investment team and serves as a generalist, supporting all areas of the Fixed Income team. Prior to joining Commonfund, Vincent was with Lazard Asset Management as a member of the Fixed Income operations staff. While at Lazard he was responsible for allocating trades and resolving trade problems for corporates, treasuries, municipals, asset backs and FX trading desks. He was also a supervisor in Fixed Income Accounting and a trading assistant on the Emerging Markets team. Previous experience includes positions at Morgan Stanley, Alliance Capital and Evaluation Associates. Vincent earned his M.B.A. in from New York University’s Stern School of Business and his B.A. from Fairfield University. He is also a CFA charterholder.
Vincent Kravec
Director, CFA
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James F. Meisner is a member of the Investment team and shares responsibility for asset allocation, manager sourcing, due diligence, and investment monitoring for fixed income and hedge fund portfolios. Prior to joining Commonfund, he spent twelve years at RBS Greenwich Capital, where he was Managing Director and head of research for the Portfolio Strategies Group. Prior to that, he was head of futures and options research at Yamaichi America and at Merrill Lynch Capital Markets. Jim began his business career at the Chicago Board of Trade, where he was involved in the introduction of options on bond futures. Earlier, he was an Instructor in Statistics at the University of Chicago Graduate School of Business (now the Booth School of Business). He received an AB in mathematics and an MBA in finance from the University of Chicago, and he completed coursework and examinations for a Ph.D. in econometrics as well.
James F. Meisner
Managing Director, Head of Fixed Income
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Roman Moravec is a member of the Investment team and participates in both quantitative and qualitative due diligence on funds and managers. Previously Roman was part of the Operations team where he conducted operational due diligence on hedge fund managers and was responsible for daily oversight of hedge fund and commodities programs. Prior to joining Commonfund, Roman worked for Quantitative Financial Strategies, Inc. where he was responsible for fund valuation and performance reporting. Roman began his career at Deloitte as an auditor in the financial services group. He holds an M.S. in Accounting from Pace University, a B.S. in International Business from Berkeley College and is a CFA charter holder.
Roman Moravec
Associate Director, CFA
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Disclaimer

Information, opinions, or commentary concerning the financial markets, economic conditions, or other topical subject matter are prepared, written, or created prior to printing and do not reflect current, up-to-date, market or economic conditions. Commonfund disclaims any responsibility to update such information, opinions, or commentary. To the extent views presented forecast market activity, they may be based on many factors in addition to those explicitly stated in this material. Forecasts of experts inevitably differ. Views attributed to third parties are presented to demonstrate the existence of points of view, not as a basis for recommendations or as investment advice. Managers who may or may not subscribe to the views expressed in this material make investment decisions for funds maintained by Commonfund or its affiliates. The views presented in this material may not be relied upon as an indication of trading intent on behalf of any Commonfund fund, or of any Commonfund manager. Market and investment views of third parties presented in this material do not necessarily reflect the views of Commonfund and Commonfund disclaims any responsibility to present its views on the subjects covered in statements by third parties. Statements concerning Commonfund’s views of possible future outcomes in any investment asset class or market, or of possible future economic developments, are not intended, and should not be construed, as forecasts or predictions of the future investment performance of any Commonfund fund. Such statements are also not intended as recommendations by any Commonfund entity or employee to the recipient of the presentation. It is Commonfund’s policy that investment recommendations to its clients must be based on the investment objectives and risk tolerances of each individual client. All market outlook and similar statements are based upon information reasonably available as of the date of this presentation (unless an earlier date is stated with regard to particular information), and reasonably believed to be accurate by Commonfund. Commonfund disclaims any responsibility to provide the recipient of this presentation with updated or corrected information. Past performance is not indicative of future results. For more information please refer to Important Disclosures.