Bonds as a Safe Haven
Relative to equities, the bond market has 3 essential
advantages: diversification against equity market direction,
lower volatility than equities, and a greater tendency to
protect principal. For the first time in a long time, the bond
markets are starting to lose material amounts of money.
Not since the bear fixed income market of 1994 has the
bond market had the opportunity to remind investors that
bonds can, and do, lose value.
In general terms, the fixed income categories have
outperformed equities in the previous decade given the
collapse of the technology driven exuberance of the early
2000s and the fiscal crisis of the late 2000s. Even more
generally, over the past 30 years, bonds have demonstrated
a tremendous ability to preserve principal. A key driver
of bond market out performance regards interest rates; for
the past 30 years, interest rates have taken a significant
downward trend. In simple terms, when interest rates go
down, bonds gain value.
What changed?
The problem for fixed income that primarily relies on
interest rate movements (like Treasuries or government
backed Agencies) is that interest rates can’t really fall any
further. The Federal Reserve is signaling a “tapering”
down of their extraordinary measures (Quantitative
Easing) which support the fixed income market, and they
now project an end to the QE program by the middle of
next year. This action is a necessary prelude to a potential
increase in interest rates. Again, the simplification is when
interest rates go up, bonds lose value. Several members
of the Fed have dissented from the Chairman’s proposed
timelines for interest rate increases and suggest a hawkish
interest rate policy to contain inflation. To be clear, the Fed
consensus for increasing interest rates is still more than a
full year away (late 2014-2015), but the bond markets –
sensing the shift in tone – have been punishing for investors.
First: acknowledge a potential
tactical disadvantage
We are afraid that many investors have simply forgotten
that bonds can lose value and they are going to be surprised
by the next month’s statements. More importantly, an
increase of interest rates now seems inevitable and the
reversal of this long term bias towards fixed income may
disappoint investors. The reasons for investing in bonds are
not completely absent now that there are signs of interest
rate increases; for example, even an asset class with a long
term return projection of zero might find its way into an
optimized, efficient portfolio if it had sufficiently negative
correlations to other return-seeking asset types. Still, it is
important for investors to recognize the potential tactical
disadvantages of classic core bond portfolios. Depending
on the ability of an institution to conduct appropriate due
diligence, the fixed income mandate for a portfolio may
expand to include non-core elements such as multi-sector,
unconstrained, total return, or global fixed income products
which expand the risk and exposure beyond interest rate
driven risk.
Second: revisit your
strategic asset allocation
Another other key consideration in the wake of these
changes: asset allocation modeling. When determining an
optimal asset allocation for a portfolio, consultants often
rely on asset allocation software which uses historical data
to figure out optimal portfolios based on the risk and return
profiles of different asset classes. Asset allocation software
works by comparing the risk, return and correlation
of different asset classes over their longest concurrent
timeline. Again - over the past 30 years, interest rates have
trended down so bond market performance has enjoyed a
structural advantage. In order to have a fair comparison
of bonds and equities, asset allocation software should
historical data beyond 30 years the downward interest rate
trend, which otherwise would bias the results. The problem,
however, is relatively new and significant asset classes
– Emerging Markets, Hedge Funds and so forth – do not
have historical returns greater than 30 years. Thus, asset
allocation software has a built in structural bias because
of the interest rate trend. Investors should be wary of this
bias and check to see if their asset allocation decisions have
incorporated this bias. Consultants using asset allocation
software should disclose and, if appropriate, account for
this bias.
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