Fixed income securities have been around for much of modern history and have continually been used as an allocation in a diversified portfolio, providing ballast when other riskier asset classes are struggling. The below chart confirms this by highlighting all rolling 3 month draw downs in the S&P 500 over the last 5 years and how the Barclays Global Aggregate Index, hedged to USD, has performed over the same periods.
However the basic concept of fixed income for most investors is to generate a set, regular form of income over a period of time and this has not changed. If in doubt check Investopedia…
A fixed-income security, or bond, is a loan made by an investor to a government or corporate borrower. The borrower promises to pay a set amount of interest, called the coupon, on a predetermined basis until a set date.*
What has changed however is the amount of yield (or coupon) that these securities or bonds are now providing. A multi decade bond bull market, which has been driven by a dramatic fall in interest rates as both growth and inflation have trended down, has reduced the yield of the Barclays Global Aggregate Index from 5.56% at the beginning of the 21st century to 1.22% today.** The below chart shows how this fall in yields has dramatically impacted the breakdown of returns from traditional fixed income indices.
Rewind to the mid-2000s and you can see that the Global Aggregate Index provided a nice, consistent coupon return with the capital return only marginally adding or subtracting from the overall performance. Compare that to the last few years and it can be seen that the income return has come down while the capital loss or gain has increased, and has become a larger component of the overall return. Unfortunately for investors, in our opinion, this current situation is not reversing any time soon. Coming out of our Investment Quarterly (IQ) meeting it was concluded that secular stagnation is here to stay. A global economy still weighted down by a substantial debt burden will continue to suffer from sub trend growth and low inflation. Central Banks are well aware of the predicament and will remain accommodative, keeping interest rates at low levels and looking for new ways to stimulate economic growth.
While the returns data in Chart 1 highlights that a proportion of a clients fixed income portfolio should remain in core fixed income assets for portfolio diversification, it is becoming apparent that investors should also diversify and look at other ways to generate returns; make their fixed income allocation work harder for them to generate an income that is no longer available from just ‘clipping the coupon’. To do this, investors need to look outside their core sector and focus on opportunities across all fixed income asset classes and across all countries. Although core yields remain low, credit spreads both in investment grade and high yield look to be fair value and can tighten from here, while the recent improvement in Emerging Market fundamentals – growth and earnings – are creating opportunities in this space for the first time in a number of years. Additionally investors should look for the ability to dial up and down the duration risk of their portfolio. We do believe that yields are likely to remain low for the foreseeable future but that doesn’t mean they will not move. With Central Banks dominating the markets, any surprises and/or disappointments could well cause heightened volatility and as Chart 2 highlights investors no longer have the coupon cushion to withstand this.
In this environment, what was historically a case of ‘accruing’ income will need to become a case of ‘manufacturing’ income. If this change in investment mentality is embraced, fixed income investors will live long and prosper.
**Bloomberg, Barclays Global-Aggregate Yield To Worst 7th October 2016