The Herbs & Spices of Bond Markets
Cooking up the right bond dish requires a careful balance of herbs and spices. Every investors pallet is different but the right blend can help perfect a dish.
Any decent chef knows that adding some herbs and spices to a meal can make or break the dish. A little rosemary and some thyme can work wonders in a chicken pot pie. The right culmination of spices can really make a curry pop. However, if a cook gets too carried away then the meal can be easily spoilt. This delicate balance is the same challenge that confronts investors trying to construct their fixed income portfolios – what fixed income asset classes can we add that produces the right balance for investors without spoiling the performance of the overall portfolio?
Start with the seasoning
As with most recipes let’s start with the basics and discuss seasoning. At the core of most bond portfolios is government debt. As we can see in the below chart shows the yield on US Treasuries is typically lower than other part of the fixed income universe however, it offers valuable diversification to portfolios by being negatively correlated to the S&P 500 over the last decade.
US Treasuries are widely considered to be a ‘safe asset’ for investors, in many ways comparable to adding salt and pepper to a dish. Salt and pepper are simple and predictable ingredients. A bit of seasoning is rarely going to spoil a dish however, I have never had a dinner party where anyone has complimented the chef on adding the right amount of pepper to the food! In order to make an impact and enhance returns investors typically need to add something with a little extra kick to liven up their portfolios.
Experiment with some herbs
More experienced chefs might reach further into the cabinet to try and find some thyme or rosemary. This part of the fixed income market contains Mortgage-Backed Securities (MBS) and Investment Grade (IG) Corporates. IG corporates are some of the largest, most established, companies in the world. Issuers such as Apple, Microsoft and Johnson & Johnson are all highly rated companies with reliable track records of consistently honoring their financial obligations. Bond yields in IG credit have increased over the last few quarters and investors can now receive yields of 4-5% while getting exposure to companies with strong corporate balance sheets.
However, these bonds do have a slight positive correlation with equity markets and should still be used with some caution. MBS and IG holdings help enhance returns but do not offer much protection versus equities in a portfolio due to their positive correlation however, they should be able to complement a basic portfolio without drastically changing its taste, just don’t go overboard. As Gordon Ramsey once yelled at a poor junior cook: “You used so much thyme Dr. Who arrived in the Tardis to save us all”.
Red Hot Chili Peppers
Now we are getting towards the spicier end of the fixed income spectrum including asset classes such as high yield, emerging market debt, convertible bonds and subordinated banking debt. These colourful markets aim to entice investors with juicy looking yields of over 6% making a meaningful difference to long-term portfolios returns. However, this additional spice comes with significant risk. Returning back to the chart, these bonds are all highly correlated with equity markets, meaning if the S&P 500 falls sharply these markets are all likely to be falling right alongside them. This lack of diversification means that investors will really feel the impact if financial markets begin to drawdown. Risk-conscious investors should probably look to use these markets sparingly in their portfolios as adding this level of spice to a dish is likely to have quite the impact and could be overwhelming for some pallets.
Personally, I can’t stand the heat. One nibble of spice and I am dashing for the milk. The same is true with how I believe bond portfolios should be used in client’s portfolios. Fixed income should be dependable and predictable – much closer to standard seasoning than red hot chilis. However, for bond investors who are braver than me then this area of the market can add some kick to investors’ portfolios.
Where is the sweetest spot in bond markets currently?
There are a huge range of different parts of the fixed income spectrum we could focus on however, the one part that stands out to me currently is the Investment Grade (IG) corporate bond market. IG is offering some attractive yields not just versus history but also relative to equities for the first time in over 13 years.
TINA is dead
Since the Financial Crisis and the onset of uber-easy monetary policy there are few compelling arguments that could be posed to investors as to why they should favour bonds over equities. The low (or even negative) interest rate environment that central banks had moved to had sucked much of the return potential out of the bond market. In response, investors piled into equities. You may have heard about the TINA equity trade – There is No Alternative to equities.
With inflation returning, policymakers have had to respond by tightening monetary policy and, like a phoenix from the ashes, the yields have suddenly returned and bonds are suddenly competitive again versus equities. The best chart to show this change in fortunes is highlighted below. The earnings yield of the S&P 500 compared to the yield of U.S Investment Grade corporates over time. Notice that in the last few months IG companies have staged a remarkable comeback after 13 years of looking persistently unattractive versus equities.
The best of both worlds
But it is not just about the attractive valuations that are worth considering, the relative risk between US equities versus US IG is also a focus point. The average credit quality of the U.S Investment Grade benchmark is A- in comparison the S&P 500 has a BBB rating but with over 100 companies that have a junk rating or are unrated. In addition, a bond investor has a preferential position in the capital stack to equity holders offering the prospect of more stable security performance further enhancing the risk-adjusted returns. In short, IG is just offering a better risk-adjusted investment outcome considering the current return, the relative credit quality of the underlying companies and a bond investors more favorable position in the capital structure.
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