Fixed Income 3 ways

Author: Michael Contopoulos, Director of Fixed Income

Today calls for a Balanced approach to Fixed Income

The discussion of the role of fixed income in portfolio allocation, given historically low global yields, has hit a fevered pitch. Most recent academic and street research has focused on the limitations of fixed income as a reliable hedge to stocks, thereby casting doubt on the benefits of fixed income within a larger multi-asset portfolio. However, fixed income should neither be thought of as one uniform asset class, nor solely as a hedge. Navigating a low yield environment is not a new challenge. Since 2016 nearly 25% of the world’s fixed income products have carried a negative yield (Chart 1) and corporate bond returns have nonetheless delivered mid-to-high single-digit returns (Chart 2). In fact, over most of the last 40-year bull market in fixed income, corporate bonds have generated equity-like returns with less volatility. The days of outsized total returns are likely gone for the foreseeable future, but careful and thoughtful allocation within the $100 trillion fixed income market should provide continued opportunities for almost any investor.

One size doesn’t fit all

The key to fixed income investing is understanding fixed income is a collection of assets with unique features and utilizing the right instrument at the right time. Chart 3 shows that different segments of fixed income can have dramatically different returns during the same period. For example, in the first quarter of 2020, investment grade credit returned -3.0%, mortgages returned +2.8% and treasuries returned +8.2%. Indeed, rather than taking a 1 or 2 dimensional view of how fixed income should be used within a portfolio (tax benefits or market hedge), with proper asset selection and active management, a skillful investor can use fixed income to enhance portfolio returns, insulate a multi-asset portfolio from an economic downturn, and/or provide additional balance during uncertain times.

As Chart 4 shows, through proper asset selection, fixed income can deliver excellent total and risk-adjusted returns alongside equities: Long-dated investment grade corporate bonds from March through July returned 42%, outpacing the 36% total return in the ACWI Index. Conversely, skillful active management can help hedge poor equity performance – even within a low-rate environment - as long-dated Treasuries did earlier this year (Chart 5). The environment today seems to warrant a more “all-weather” fixed income approach to complement a larger balanced equity portfolio. Chart 6 highlights that a 50/50 portfolio balancing credit risk (IGBH*) with medium to long-term Treasuries (TLH*) would have returned 2.1% since September 1st - outperforming the Bloomberg Aggregate index by 180bp - with the credit portion providing exposure to the recovery and the Treasuries acting as a ballast during periods of volatility and uncertainty.

Balancing the portfolio between credit risk and rate risk while complimenting other areas of a broader portfolio is the key to allocating in fixed income. And as the economy improves – and profits, liquidity and sentiment become more attractive – there will be plenty of areas of opportunity to provide outsized returns and attractive income, while still providing a hedge against rising US rates. Fixed income may be down, but we don’t think it’s out. *the security is currently held in a portfolio managed by RBA.