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Market Volatility
Bond market perspective: Why it’s important to stay strong at the core
Mike Gitlin
Head of Fixed Income
Margaret Steinbach
Fixed Income Investment Specialist
Ritchie Tuazon
Fixed Income Portfolio Manager
KEY TAKEAWAYS

 

  • Fixed income valuations were stretched before this volatile period
  • Many years of excesses need to unwind as leverage remains high
  • A core bond portfolio should provide diversification and capital preservation

Needless to say, it’s an unusual time. We won’t add to the noise that “markets are volatile” or make other obvious statements. Rest assured, we see that reality and are working hard to manage through the challenges associated with dislocated and somewhat illiquid markets.


The reset in asset prices over the past several weeks has been driven by the fear of an economic downturn. As we move forward, the driving force behind the continued reset will be the reality of much weaker growth and sharply lower corporate earnings.


The likelihood of a recession rose sharply in early 2020. The chart shows a line tracking the New York Fed’s recession probability indicator since 1962. It also shows when past recessions occurred and a 30% probability threshold line. When that threshold has been reached, a recession has often followed within 12 months. According to this measure, the probability of a recession has been increasing in recent months and reached 27% in March 2020. Sources: Federal Reserve Bank of New York, Refinitiv Datastream. As of March 31, 2020. Shaded bars represent U.S. recessions as defined by the National Bureau of Economic Research.

 


We know from past downturns and periods of volatility that often the best course for investors is to stick to their individual plans. In equities, popular wisdom argues that you should maintain a long-term focus, stay invested and take advantage of dollar cost averaging through the downturn.


In bonds, however, now is the time to take a closer look at what you own.


Interest rate outlook: Lower for even longer


We’ve been preaching “lower for longer” for years. In March, U.S. Treasury yields reached new all-time lows as the Federal Reserve cut its policy rate to 0.00%–0.25%. With the return of zero interest rate policy, the discussion of negative rates in the U.S. will begin in earnest.


Chart shows that lower rated investment-grade corporate debt has ballooned in recent years. As a percent of the investment-grade universe, BBB-rated U.S. corporate bonds have risen from just under 25% in 1995 to a high of 52% in 2019. Source: Bloomberg Index Services Ltd. As of March 31, 2020. Bloomberg Barclays U.S. Corporate Investment Grade Bond Index used to represent investment-grade corporates.

It’s not our base case that we see a negative policy rate in the U.S., but everyone should be prepared to hear more noise on this front. Although U.S. rates are closer to the zero lower bound now, they still have room to fall if, for instance, the economic recovery takes longer than expected.


Market Volatility Center

Find resources to help clients navigate the current crisis.

Leverage remains high


During a recessionary period, we know credit becomes challenged. Our starting point adds to the difficulty: Going into this downturn, the riskiest segments of the credit market (BBB-rated investment-grade corporate debt, high-yield credit and leveraged loans) had reached a 20-year high as a percentage of GDP at 25%. Notably, BBB debt as a percentage of the investment-grade credit market had also ballooned to roughly 50% of that universe.


Working through this imbalance will take time. We also expect the unwind and repricing of risk in the market will continue to be exacerbated by a lack of liquidity. In the initial price decline, banks quickly reached balance sheet risk limits. Investors who have been blindly riding the credit wave for years haven’t been able to unwind, even if they wanted to do so.


The lack of liquidity has been more severe in this downturn compared to the 2008–09 financial crisis. Measures have been taken to alleviate stress in the system, and they’re helping, but it’s unlikely that we will see markets return to their pre-COVID-19 complacency.


Excesses need to unwind


As spreads in corporate credit have widened substantially, we are now less defensively positioned, but we remain risk aware as we evaluate new opportunities. Years of excesses still need to unwind. We will ultimately find value, as we did in recent weeks when credit spreads — the difference between yields offered by U.S. corporate debt and Treasuries — hit their widest levels. We will continue to take advantage of opportunities on a security-by-security basis, viewed through the eyes of our experienced analysts.


We’re still mindful that we’re likely to shift from the “hope” that’s driven the recent rebound in asset prices to the “reality” stage reflecting the weak current state of our economy.  With a lot still unknown, spreads have the potential to move wider again, notwithstanding central banks that have gone all-in, particularly in those areas of the market that were not previously supported by central bank purchases or lending programs. Over time, further credit spread widening may present attractive entry opportunities.


Stay strong at the core


In previous commentaries, we’ve talked about “upgrading the core” of your fixed income allocation. That message is more relevant today than ever. Our view is that now is the time to stay strong at the core, remain risk aware and avoid the temptation to reach for yield. Even with historically low Treasury yields, it’s not too late to make sure your bond portfolio is doing what it should — providing diversification from equity exposure and preserving capital.


Core bond funds have provided diversification from equities in recent periods of volatility. Graphic shows a series of bar charts for each of the five recent periods when equities fell 10% or more, as well as the results of the Morningstar Intermediate Core Bond Category Average, Morningstar Intermediate Core-Plus Category Average, Morningstar Multisector Bond Category Average and S&P 500 Index, respectively. The Core category contains portfolios that invest primarily in investment-grade U.S. fixed-income issues and hold less than 5% in below investment-grade exposures. The Core-Plus category contains portfolios that invest primarily in investment-grade U.S. fixed-income issues but have greater flexibility than core offerings to hold non-core sectors such as corporate high yield, bank loan, emerging markets debt and non-U.S. currency exposures. The Multisector Bond category contains portfolios that seek income by diversifying their assets among several fixed income sectors, usually U.S. government obligations, U.S. corporate bonds, foreign bonds and high-yield U.S. debt securities. These periods include the flash crash in 2010, U.S. debt downgrade in 2011, oil price shock in 2015–2016, the global selloff in late 2018 and the coronavirus crisis in 2020. In all periods, the core category average outpaced the other categories and the stock index. Source: Morningstar. Dates shown for market corrections are based on price declines of 10% or more (without dividends reinvested) in the unmanaged S&P 500 with at least 50% recovery persisting for more than one business day between declines for the earlier four periods shown. The most recent period is still in correction phase as of March 31, 2020. The returns are based on total returns in U.S. dollars.

During this volatile period, many investors have been surprised to see their bond funds fail to perform their intended role. For example, all five of the largest core-plus bond funds declined in the month of March, posting an average loss of 3.3%. And even some short-term bond funds have struggled, producing negative returns in this environment.


Be mindful that bond funds with “core plus,” “total return” or “income” on the label tend to be overweight lower rated corporate credit, emerging markets debt and structured products, and they can be significantly underweight Treasuries. That’s not to say you shouldn’t own these types of funds at all, as they can be important components of an overall bond allocation, but they probably should not occupy the largest portion of a well-diversified bond portfolio.


The truth is, no one knows what will happen next. But you can focus on making sure that as the highs and lows of these volatile times continue, your fixed income portfolio is designed to absorb the shocks and provide a measure of stability when you need it most.



Mike Gitlin is head of fixed income at Capital Group. He has 25 years of investment industry experience. Before joining Capital in 2015, Mike was head of fixed income and global head of trading for T. Rowe Price. He holds a bachelor's from Colgate University.

Margaret Steinbach is a fixed income investment director at Capital Group. She has 13 years of investment industry experience, four with Capital. Previously, Margaret worked as a portfolio specialist at Oaktree Capital Management. She holds a bachelor’s degree in commerce from the University of Virginia.

Ritchie Tuazon is a fixed income portfolio manager at Capital Group. He has 19 years of investment industry experience, including seven years at Capital. Previously, Ritchie worked as a bond trader at Goldman Sachs. He holds an MBA from MIT, a master's in public administration from Harvard and a bachelor's from the University of California, Berkeley.


The Morningstar Intermediate Core Bond Category Average contains portfolios that invest primarily in investment-grade U.S. fixed-income issues and hold less than 5% in below investment-grade exposures. The Core-Plus category contains portfolios that invest primarily in investment-grade U.S. fixed-income issues but have greater flexibility than core offerings to hold non-core sectors such as corporate high yield, bank loan, emerging markets debt and non-U.S. currency exposures. The Multisector Bond category contains portfolios that seek income by diversifying their assets among several fixed income sectors, usually U.S. government obligations, U.S. corporate bonds, foreign bonds and high-yield U.S. debt securities.

 

Bond ratings, which typically range from AAA/Aaa (highest) to D (lowest), are assigned by credit rating agencies such as Standard & Poor's, Moody's and/or Fitch, as an indication of an issuer's creditworthiness. If agency ratings differ, the security will be considered to have received the lowest of those ratings, consistent with the fund's investment policies. Securities in the Unrated category have not been rated by a rating agency; however, the investment adviser performs its own credit analysis and assigns comparable ratings that are used for compliance with fund investment policies.

 

The return of principal for bond funds and for funds with significant underlying bond holdings is not guaranteed. Fund shares are subject to the same interest rate, inflation and credit risks associated with the underlying bond holdings. Investments in mortgage-related securities involve additional risks, such as prepayment risk, as more fully described in the prospectus. Higher yielding, higher risk bonds can fluctuate in price more than investment-grade bonds, so investors should maintain a long-term perspective.

 

Standard & Poor’s 500 Composite Index is a market capitalization-weighted index based on the results of approximately 500 widely held common stocks.

 

Bloomberg® is a trademark of Bloomberg Finance L.P. (collectively with its affiliates, “Bloomberg”). Barclays® is a trademark of Barclays Bank Plc (collectively with its affiliates, “Barclays”), used under license. Neither Bloomberg nor Barclays approves or endorses this material, guarantees the accuracy or completeness of any information herein and, to the maximum extent allowed by law, neither shall have any liability or responsibility for injury or damages arising in connection therewith.

 

© 2020 Morningstar, Inc. All rights reserved. The information contained herein: (1) is proprietary to Morningstar and/or its content providers; (2) may not be copied or distributed; and (3) is not warranted to be accurate, complete or timely. Neither Morningstar nor its content providers are responsible for any damages or losses arising from any use of this information. Past performance is no guarantee of future results.

 

Standard & Poor’s 500 Composite Index is a product of S&P Dow Jones Indices LLC and/or its affiliates and has been licensed for use by Capital Group. Copyright © 2020 S&P Dow Jones Indices LLC, a division of S&P Global, and/or its affiliates. All rights reserved. Redistribution or reproduction in whole or in part are prohibited without written permission of S&P Dow Jones Indices LLC.

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