Right around this time last year, we were spending a lot of time talking to clients about fixed income. Most were concerned about their fixed income returns compared to what equities were doing, and many even posed a very direct question, “Why do we even own fixed income?”. Some of these questions were being asked rhetorically as I believe most investors know they needed fixed income in their portfolio, they were simply frustrated that a seemingly “safe” asset class was actually providing negative returns. Others were probably more serious, seeing that it was obvious that bonds were going to provide negative returns for the foreseeable future, and under no circumstance did that seem appealing. To be honest, it was a very fair question and one that was being asked by almost everyone. But, as often happens in markets, trades that seem so obvious in the moment have a way of humbling everyone.
Most investors understand rates have come down over the past 8 months. Most have also been informed by some medium that the yield curve has inverted. While the media has shouted those two facts ad nauseum (we are guilty too), they have failed to discuss how these things affect fixed income returns. They have almost completely ignored the concept of duration. Duration is a fancy way to describe the relationship between interest rates moves and the prices of bonds. In its simplest form, if a portfolio of bonds has a duration of 5, if interest rates move down 1% (from 3% to 2% for example), the value of that portfolio of bonds should increase by 5%, and vice versa. Remember, bond prices move in the opposite direction of interest rates.
The chart above shows the 1 year trailing returns for three different bond ETFs, all with varying durations. The orange line represents PIMCO 25+ Zero Coupon Bond(ZROZ), the blue line is Schwab US Aggregate Bond(SCHZ) and the red line is iShares 1-3 year US Treasury Bond(SHY). The duration is 27 for ZROZ, 5.7 for SCHZ and 1.88 for SHY. As you can see, the higher the duration, the bigger the price moves. This chart does a good job putting some perspective around the volatlity we have seen in rates over the past 12 months.
Why Do We Care?
My guess is that most investors don’t realize the Barclays Aggregate Bond Index (the S&P 500 for bonds) is up 9.11% YTD. Better yet, I’m fairly certain almost no one realizes that if you had purchased ZROZ on January 1st, you would currently be outperforming the S&P 500 by approx. 18.5% so far this year!! Behold, the power of Duration. While it is easy to look at charts and think about what might have been, we still need to manage our fixed income positions around these rate moves, and duration is a large part of that.
Investors own fixed income for two reasons: stability and income. Unfortunately, income has been hard to come by over the past 10 years. After the Fed slashed short-term rates during the Great Financial Crisis, fixed income investors were facing a dilemma: if you wanted higher income you needed to be willing to take on more risk through either duration or credit risk. As far as stability goes, US Treasury bonds remain one of the most effective hedges against large market drawdowns. Even outside of those extreme events, bonds don’t historically exhibit the amount of price volatility you see in equities.
Last year was the first time in a while where investors were facing negative returns from bonds as rates moved higher. With the expectation for rate increases through 2018, both from market forecasts and the Fed’s own guidance, HCM made the decision to add more short duration exposure to our bond positions around March 2018, allowing us to lower our overall duration and expose clients to less price risk. The tradeoff at the time was a slightly lower level of income for less price risk. As the Fed has changed its guidance, risks have increased, and rates have continued dropping throughout 2019, we slowly removed some of our shorter duration fixed income positions and increased duration. We still hold some shorter duration positions in our fixed income portfolio, mainly due to the fact we can now get slightly higher levels of income as compared longer duration products. This is one of the direct effects of the yield curve inversion. The tradeoff is if rates continue to move lower, we may not experience as much price appreciation on our fixed income positions. We feel comfortable with this tradeoff as our current positioning allows us a strong combination of income and price stability, yet we still have enough duration help offset further equity volatility.
Most strategists are forecasting that rates will continue to move lower through the end of 2019. They are about as sure as they were that rates were going to continue to move higher through 2018.
Weekly Focus – Think About It
“Doubt is not a pleasant condition, but certainty is absurd.”
Performance last week for the four major asset classes were:
- U.S. Stocks – Russell 3000 (IWV) – Loss of -1.39%
- Developed Foreign Markets (EFA) – Loss of -0.47%
- Emerging Markets (EEM) – Loss of -1.24%
- Fixed Income (AGG) – Gain of 0.10%
(Note: performance is based on the change in price plus dividends)
Last Week’s Headlines
- The US decided to delay imposing tariffs on some Chinese imports to Dec 15 from Sept 1, which led to a rebound for US stocks.
- As escalation of civil unrest in Hong Kong forced cancellations of flights in and out of the city’s airport, one of the busiest in the world.
- Germany’s ZEW survey suggest elevated concerns over the health of the economy, which contracted in the second quarter as expected.
Eye on the Week Ahead
- Focus will remain on the ongoing tariff issues between China and US. Investors will be looking for any improvement in rhetoric between the two sides.
If you have questions about the recent market conditions, please contact a member of HCM’s Wealth Advisory Team:
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