Who Needs Bonds Anyway?
They don’t pay much interest, and future price appreciation is so not happening. Still, they have their uses.
Art by Alfonso de Anda
The funeral bell is tolling for the great bond rally. So why bother with bonds anymore? Amid minuscule interest rates, that’s a valid question.
The rally began life in the 1980s, when interest rates started their long descent from the high teens, a fall that propelled prices aloft. Powered by the Federal Reserve’s then-chairman, Paul Volcker, the bond market put some spring back in the step of fixed-income investors.
Yet now, with short-term rates near zero in a bid to boost borrowing during the coronavirus recession, not a lot of runway is left for price appreciation. The classic equation is that lower rates bring higher bond prices. Trouble is, rates can’t go lower than zero. (OK, they have negative rates in Europe and Japan, although Wall Street and Fed sentiment against them here is high.)
The future doesn’t appear exactly sparkling for fixed income. With investment grade corporates, for instance, the prospect is that “there is no alpha to be had,” noted Scott Colyer, CEO of Advisors Asset Management. Fed Chairman Jerome Powell confirmed in August that “lower for longer,” as the phrase goes, will be the norm for short-term rates for years to come. While longer-term fixed income is strongly influenced by economic forces other than Powell, the Fed’s policies have an influence on these bonds.
Nevertheless, bonds should remain a vital, if reduced, part of institutional investors’ asset mix. Why? “Diversification, liquidity, and black swan insurance,” said Jim Keegan, CIO and chairman of Seix Investment Advisors.
In other words, with price appreciation a memory, they will continue to serve their other long-standing function, as a ballast against the bad times. Also, it’s still possible to generate commendable returns via smart trading, which is the province of adept pros. Plus, some opportunities remain in junk bonds, whose rates are relatively higher, giving pricing some leeway.
Bonds’ Plight
Overall, bonds have become also-rans in institutional portfolios. The trend has been for large investors to decrease their relatively risky equity holdings and, looking for good replacements for stocks’ growth powers, to turn to alternatives such as private equity, hedge funds, and real estate. Not so much to bonds.
For public pension plans, fixed income was 27.8% in 2005, and last year that had fallen to 22.9%, along with the decline in interest rates, the Public Plans Database shows. Stocks dropped to 47% from 61%. The situation is similar for corporate defined benefit (DB) plans, with stock allocations shrinking and alts gaining—the bond portfolio nudged up a small amount over the past five years, to 43% from 39%, a Conning study indicates. Corporate programs, not laboring under the weight of political demands, are more interested in de-risking than public plans, so bonds, more liquid than most alts, are more welcome there.
One piece of good news: Bonds have the assurance that the Federal Reserve has their back, with a commitment to buy investment grade corporates and fallen angels, namely bonds that recently have tumbled into speculative territory.
At the same time, the benchmark 10-year Treasury note has seen its yields dip dizzyingly low. Look at what has happened over the past five years. The 10-year’s yield started out at 2.2% in early September 2015, then moved up to 3% by year-end 2018, as the Fed shucked its controversial rate-hiking campaign. From there, it has been a steady slide to 0.66 as of Wednesday’s market close.
Yield Dwindles on Benchmark 10-Year Treasury Note
10-Year Treasury Constant Maturity Rate, Monthly, Not Seasonally Adjusted
3.5%
3.0%
2.5%
2.0%
1.5%
1.0%
0.5%
9/15
9/16
9/17
9/18
9/19
9/20
3.5%
3.0%
2.5%
2.0%
1.5%
1.0%
0.5%
9/15
9/16
9/17
9/18
9/19
9/20
3.5%
3.0%
2.5%
2.0%
1.5%
1.0%
0.5%
9/15
9/16
9/17
9/18
9/19
9/20
3.5%
3.0%
2.5%
2.0%
1.5%
1.0%
0.5%
9/15
9/16
9/17
9/18
9/19
9/20
Source: Economic Research Division, Federal Reserve Bank of St. Louis
The shrinking difference between long and short rates illustrates how much we are living in a low-rate world. Five years ago, the spread between the three-month T-bill and the 10-year was 1.5 percentage points. As of yesterday, that has narrowed to a mere 0.54.
Ballast
During the horrible 2007-09 Great Recession, bonds showed how they can help a portfolio whose stocks have been slammed. According to a study by asset manager BlackRock, the S&P 500 plummeted 43.3% in that period, while the Bloomberg Barclays US Aggregate Bond Index (aka the Agg)—which includes investment grade corporates and Treasuries—gained 5%. Not enough to erase the stock slide, but a partial help. In this year’s virus-ravaged first quarter, the S&P 500 fell 19.6%, and the Agg was up 3.2%.
Over time, stocks have shown their historic capability to outperform everything else. In the space of five years, the S&P 500 has climbed an annual 15.2%. Junk bonds are up 5.1%, investment-grade corporates 9.2% and long-term Treasuries 8.4%. That is, not even close to equities.
Those fixed-income performance numbers likely will decrease, because the Fed actions that are buoying them for now won’t last forever. Bonds will keep on delivering dependable and uninspiring returns—with the saving grace that they’ll do so without the wrenching volatility of stocks.
The only thing that could erode bonds’ use as a ballast is increased inflation, and, by extension, higher interest rates, even if precious little inflation is around lately. The odds of worrisome levels of inflation occurring, however, are slender. The central bank shrugs off the likelihood of meaningful inflation. As Fed Chairman Powell demonstrated during his Jackson Hole, Wyo., speech last week, even a tiny whiff of inflation won’t push the central bank into quickly hiking rates. “The Fed is on hold,” said Jeff Klingelhofer, co-head of investments at Thornburg Investment Management.
True, with all the money that the Federal Reserve and Congress have pumped into the economy, some believe that a degree of inflation will return at some point, likely after the recession. If so, “bonds will see prices cut,” Advisors Asset Management’s Colyer said. “And it won’t be pocket change.” Just the same, nobody thinks bonds yields will go higher than mid-single digits.
Meanwhile, a big constituency is pushing for rates to stay ultra-low. The capital markets, in particular the stock exchanges, are hooked on low interest rates. Powell and his predecessor Janet Yellen tried lifting short-term rates from near-zero, where they’d sat since the 2008-09 global financial crisis—and the mounting outcry from the finance world compelled the Fed to pull rates back down.
Nimble Trading
The key to squeezing any return out of bonds is “to be nimble,” Thornburg’s Klingelhofer said. Often, this entails playing defense so as to not get squashed by unexpected developments. To accomplish this, many bond managers like to stay in short-term bonds. The reason: Despite the tiny yields, their prices are less vulnerable than paper with longer maturities.
Other, more enticing opportunities are around. Klingelhofer pointed to bonds of Southwest Airlines. Yes, airlines aren’t doing well these days, but Southwest is in solid shape: After a losing first quarter, its first in nine years, the carrier returned to profitability in the second period.
Better, the company has very little debt around its neck. Hence, Southwest’s bonds, which have investment grade ratings (BBB+ from Standard & Poor's), are a good bet to keep paying interest and to return principal at maturity. One issue, due to mature in November, yields around 2.6%, which is 2 percentage points better than a 10-year Treasury.
Certainly, bonds can still generate decent returns through canny trading. Consider Trans-Canada Capital (TCC), which runs Air Canada’s pension plan. This year, through mid-August, the plan (US$17.6 billion in assets) logged a 16.5% return on fixed-income holdings, 3.25 points above its benchmark. Bond trades are deftly done at TCC, whose portfolio has an unusually large amount of fixed income, some 74%.
One lucrative, hedge-fund-like technique TCC deploys is relative value trading. The maneuver exploits temporary differences in the prices and yields of similar bonds. Yield curves differ, country to country, thus providing openings for smart traders. For instance, “the US curve is steeper than Canada’s,” said Marc-André Soublière, senior vice president for TCC’s fixed income and derivatives operation.
Another clever trade was to buy a sizable amount of 100-year bonds, yielding around 2.3%, from Canadian provinces and several other countries. As anything can happen in the long course of a century, these long, long, long bonds usually aren’t popular instruments. When interest rates descended to zero in the spring, the 100-year issues became wildly attractive. Capital appreciation, Soublière said, surged 32%,
The Junk Exception
In the view of investing savant Jeremy Grantham’s GMO, investors should forget Treasuries, since they don’t pay much. Instead, the firm argued in its recent newsletter, go for junk.
Junk bonds deliver more yield, of course, to compensate for their greater risk. These days, though, the yield gap between them and investment grade corporates is not wide, signaling that investors think the speculative paper won’t get wiped out in this recession. Junk’s average yield is 5.4%, versus 2.4% for BBB corporates, the lowest rung of investment grade—and also the biggest, comprising half of IG issues.
That 3 percentage point spread between high-yield and BBBs is a marked contrast to the 5.6 point gap in late March. “High-yield returns are skinny, but they’re better than the alternative,” everything else, said Steve Hooker, a portfolio manager at Newfleet Asset Management.
To be sure, recessions are unkind to high-yield bonds, but this one isn’t as bad for them. Junk default rates were 10.7% in 2009, their worst point during the Great Recession. Right now, Moody’s Investors Service places the rate at 5.5% and forecasts that defaults will top out at 7.6% by year-end. Earlier predictions put the number above 2009’s, with some estimating that the level would reach 12% or worse this year.
A big reason for the less dire situation is Powell’s buttressing the bond market. While Fed purchases of fallen angel junk have been small, the psychological guarantee of central bank support is sufficient to bolster high-yield. Another plus for junk, said Mike Kirkpatrick, senior portfolio manager at Seix Investment Advisors, is that today’s issues are more resilient than in the past, owing to market Darwinism that weeded out many of the weakest bonds. “We’ve been through cleaning cycles” in the 2008 financial crisis and, to a lesser extent, the 2015 economic rough patch, he said.
On the other hand, corporate America is shouldering a massive amount of debt. If the fitfully recovering economy doesn’t mend soon and goes south again, a lot of junk investors will be default-battered and very unhappy. “More investors have died reaching for yield than at the point of a gun,” said Norm Conley, CEO and CIO of JAG Capital Management.
Absent such a fate, bonds stand to retain their prosaic penchant for being dull and reliable, even if they pay a pittance.
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