Recently there have been a multitude of articles concerning how low interest rates are going to negatively impact investors. The conclusion of many of these articles is that your bond holdings should either be jettisoned or drastically changed in favor of riskier bond strategies that can earn higher returns. Below, we will highlight our view on why this is the wrong conclusion.
The Role of Fixed Income in Your Portfolio
Please note: the following applies to investors who seek a “balanced” long-term allocation, whether it be 75%/25% equity-fixed or vice versa, and does not apply to portfolios that are equity-only.
We define fixed income as strategies that at all times have relatively predictable exposures (as defined by correlation) to U.S. interest rate risk and/or credit risk. Fixed income aims to serve two primary functions in our multi-asset class portfolios:
- Be the primary ballast against equity volatility
- Provide yield/income
Although equity volatility has been at historically low levels, this won’t last forever. When equity volatility rises in a negative way for stocks, fixed income should provide some defense. Recent examples include January of 2016, when the S&P was down just shy of 5% and bonds (as defined by the Barclays Aggregate U.S. Index) rose around 1.25%, or more recently during the “Brexit” volatility when bonds once again provided some ballast. These are short-term and recent examples, and there are times when both bonds and stocks do poorly together. However, we expect this relationship to hold true more often than not.
Our portfolios are designed with these functions in mind and include both high-quality passive and active bond management. Our passive allocation is a cheap and easy way to obtain long-only exposure to the domestic investment-grade bond universe. We also own active fixed income managers who can invest in asset classes not included in the index (Barclays Aggregate), and diversify across different risk factors such as duration, yield curve shape, credit, and international bonds.
What Changes Are We Making as a Result of Today’s Low Rates?
As a firm, we do not make predictions about the direction of rates. However, since we are in uncharted territory with regards to the level of global yields, we felt it would be prudent to analyze our fixed income holdings.
Regarding the idea of removing fixed income entirely: a well-structured portfolio means that each holding serves a specific purpose/function. Diversification is painful for multi-asset class investors: if you love every holding in your portfolio, you are not diversified. If you expect every holding in your portfolio will contribute positively over the next 12 months, you are not diversified. Your portfolio is not a collection of isolated trades, in the same way that a piece of bread is not the same as a cup filled with water, flour and salt. As long as we believe that fixed income continues to serve either of the functions discussed above, which we believe it does, it belongs in your portfolio. Finally, even if rates do rise, it does not spell doom for a high quality bond portfolio.
What about the concept of a “tactical trade” of reducing fixed income – say, by 10% in absolute terms – in favor of cash, until rates go back up to higher levels (let’s assume a 10-yr yield at 2.5%-3%)? We are against this for a few reasons:
- We do not engage in this type of tactical allocation, which to a certain degree amounts to market timing on the direction of interest rates. For a variety of reasons, we believe the practice of tactical allocation generally reduces the amount of cash left in your pocket at the end of the day.
- The math isn’t that compelling. Even if we were to engage in this type of trading, our back of the envelope calculation finds a best case “win” of 0.5% (50 bps), and that doesn’t even consider transaction fees or taxes. Add to that the equally probable scenarios that rates go down even further, or that they remain range bound for a while, and we see little value in doing this.
- Nominal rates are near all-time lows, but “real” rates (inflation adjusted) should matter more to you when evaluating the benefit of your bond holdings. Jason Zweig’s recent article in the WSJ argues that current real rates are not so bad, despite nominal rates near all-time lows.
- Fixed Income provides important diversification value vs. equity volatility, and should be a permanent allocation for investors that seek a balanced portfolio over time.
- Portfolio allocations should be built on long term expectations, and generally revisited only for rebalancing, tax-loss harvesting, or a situational-driven change in investment objective.
- We believe the practice of tactical allocation hurts the bottom line over time and can enable bad investor behavior.
- In the case of slightly reducing fixed income in favor of cash, even the “best case scenario” amounts to noise with little impact on your ability to achieve long-term financial goals.