Fixed income reality check
The global economy has recovered, but credit markets are late in the cycle and stretched. Some popular strategies increase risk, but there are alternatives.
- Insight: Fixed income asset prices are rich, making it more tempting to chase risky assets to enhance yield.
- Implication: Many bond portfolios are taking on additional risk, exposing investors to potential downside and correlation to equity volatility.
- Implementation: Consider upgrading the quality of your fixed income portfolio using a variety of mandates.
Yield is harder to find in the typical places
Interest rates continue to be low despite the U.S. Federal Reserve's three hikes to short-term rates last year and more likely coming this year.
Yields have ticked up — but they're still relatively low
- Facing scant U.S. Treasury yields, investors are chasing it in other places. Bond investors are moving into high-yield debt to help maintain income. But in doing so, investors are chasing yield away. The average yield on the U.S. high-yield market had fallen to below 5.7% as of the end of 2017 and investors are only getting 3.43 percentage points of yield over comparable U.S. Treasuries. That's the lowest spread since the financial crisis kicked off in 2007, showing how little investors are getting paid to take incremental risk.
U.S. high-yield bond yields near 2017 lows
- Risks associated with lower quality fixed income are intensifying. As demand for high yield remains strong by income-hungry investors, new risks are evolving. Covenant protections for bondholders are being watered down or even removed, taking away even more security for investors. Risks are rising in investment-grade, too. Yield on high-quality issuers have declined to just 90 basis points over U.S. Treasuries, not far from the scant 85 basis point spread in 2007. That's despite the fact that credit quality is only marginally better.
Investor compensation for credit risk neared post-crisis lows in 2017
Fixed income investors are chasing yield — exposing themselves to additional risk
Given low rates, investors are modifying the bond fund portions of their portfolios and tilting them in ways that may make them riskier than they might seem. Bond funds classified as “strategic income,” “multisector” or “nontraditional” are taking larger weightings in fixed income portfolios with investors looking for yield. While these strategies have worked well lately, they may present unforeseen risks. Funds available in the U.S. in Morningstar‘s Multisector Bond category at the end of 2017‘s third quarter were 36% weighted in high-yield securities. That resulted in a 0.63 correlation to equity the past three years (the closer an investment‘s correlation to equity is to one, the more it tends to move in lockstep with the stock market). This correlation could prove problematic if the equity market remains volatile. The chart below shows how funds reaching for yield, tracking the Bloomberg Barclays U.S. Credit Total Return Index (right) might get a few additional basis points in return, but at a high tradeoff in larger downside risk. To explain further, the bond funds reaching for yield obtained just 54 basis points in excess return, but endured 336 basis points in additional downside based on the worst five-year cumulative rolling return.
Is the extra risk really worth the reward?
How to prepare your fixed income portfolio
Capital Group‘s research suggests it‘s time to evaluate the risk embedded in your bond portfolio and dial back risk. High yield markets are not compensating investors for the risk they‘re taking and not offering the traditional buffer from equity volatility, either.
There are several possibilities to dial back risk in bond portfolios:
Some funds have held up during periods of weakness in the equity market. Consider bond mandates that don‘t stretch for yield and remain true to their role of providing diversification from equities.
2. Diversify your sources of yield
While high yield can have a place within a diversified portfolio, you may want to consider additional sources of income. With a focus on investment-grade bonds, Capital Group World Bond FundSM(Canada) provides exposure to global bond markets — with different economic cycles, yields and currency valuations — which can add an extra layer of bond diversification.
3. Include inflation protection
Inflation-linked securities, like U.S. TIPS and Canadian Real Return Bonds, offer explicit protection against inflation. Today, more than a dozen countries issue these securities. Consider an allocation to a mandate that holds these types of securities.
How inflation protection can help a portfolio