There’s Value in Fixed Income – If You Know Where to Look

Are there better alternatives to invest in bonds given today’s fixed income market?

In the current climate, investors have become increasingly concerned that fixed income investments will no longer perform as well as in the past. Some have even begun rotating out the asset class. Four common concerns about fixed income’s ability to generate continued positive returns are:
1. A potential for significant inflation and a rise in interest rates
2. The declining value of the USD
3. Record levels of risk asset supply and level of spreads
4. Low yields, lack of income and the end of the Bull Market in bonds

We will address each of these potential threats and propose a more optimistic outlook for fixed income investors. Including answers that may lie in a new asset class. One with an options overlay strategy.

A Potential for Inflation and a Rise in Rates

The Threat: The influx of cash stimulus into the economy will increase inflation and cause the Federal Reserve to raise rates

In the first quarter of 2020 the U.S. saw one of the greatest growth slips in recorded history, a drop of –31.4%. The U.S. treasury responded by supplying a massive fiscal stimulus package. The Fed introduced an accommodative monetary policy and quantitative easing programs. In a “normal “environment, this combination of enormous economic stimulus, would likely lead to a period of inflation followed by the Federal Reserve raising interest rates.

The Outlook: The stimulus is unlikely to affect inflation or rates significantly

The reality is that there has not been any persistent price pressure. On the surface, the Treasury and Fed’s response may seem like a recipe for a potential increase in inflation. However, when compared to the swiftness and severity of the recession that followed the global economic shutdown signals that it’s highly unlikely that the outcome from these extraordinary policies would be so. Consensus GDP forecasts indicate that we will not see year-over-year GDP growth until Q2 2021 and the Federal Reserve’s own ‘Dot Plots3’ indicator shows no change in rates until 2023.

Source: Bloomberg

Price changes have been stubbornly low since mid-2007, including the Great Financial Crisis (highlighted by the circle above), where the average inflation rate over that time was 1.8%.

Additional concerns about inflation arose from high production costs as the global pandemic threatened various supply chains. However, global economic data has turned positive, albeit slowly and protracted, and proven any cost-driven inflation to be relatively benign.

Interest rates are unlikely to rise as well. The Federal Reserve has been very consistent with their messaging regarding lower policy rates for a longer period. Chair Jerome Powell recently outlined a plan that will allow the inflation rate to exceed the Fed’s 2% inflation target in order to achieve the Fed’s dual goals of full employment and price stability[1]. This should give investors some degree of comfort that the Fed will prevent shocks to the market, including a significant change in interest rate policy. While there are other factors that may weigh on longer term interest rates, short-term interest rates will remain pegged for the foreseeable future. But lower interest rates mean less cash flow from the bond portfolio. One way to supplement this is to create a better capital appreciation profile. Build’s strategies allow the investor to remain conservatively positioned in a high credit-quality bond portfolio while participating in potential upside equity moves via a long-only call positions on the equity market.

In the unlikely event that inflation did begin to appear, active fixed income managers can shorten duration (although in most circumstances, our bias is to be neutral to duration) and increase the portfolio’s credit profile to mitigate any adverse effects inflation might cause. The traditional cause of an increase in inflation is that underlying economic growth is improving, typically indicating a rising equity market. In the event inflation does appear, Build’s Indexed Risk Control offerings are well positioned to provide the anchor of an actively managed fixed income portfolio combined with potential upside equity returns using a long-only equity call options strategy.

 

The Declining Value of the USD

The Threat: The USD will lose value and cause price pressure on imported goods

While currency is not necessarily the first thing fixed income investors consider, it is an essential element of the macroeconomic landscape. Related to the inflation concerns noted above, a country’s relative currency strength or weakness can make that country’s goods more or less expensive. For instance, a weaker currency in the U.S. can make U.S.-made goods look less expensive to foreign buyers. But that same weaker USD will make the cost of buying imported goods more expensive. With the United States running a persistent trade deficit (we import more goods than we export), a weaker USD could add price pressure on those net-imported goods.

Source: Bloomberg

The Outlook: The dollar value is unlikely to affect USD based fixed income portfolios

While there needs to be vigilance concerning the USD’s impact on the economic environment, there may not be a linear relationship between the U.S. dollar level and the overall inflation level. In fact, we have seen a material move lower (~21.5% annualized) in the USD from its most recent high in March of this year, which seemingly could pose a price threat. A similar, albeit less pronounced move lower in the dollar (~12.5% annualized) from the end of 2016 to the end of Q1 2018 with little consequence to inflation during this time[2]. Irrespective of the USD recent move lower, it is important to note that the dollar is still the world’s reserve currency and is not likely to change soon. This structural support is an influential factor for USD assets. Further, regarding fixed income investing, the dollar’s impact on a portfolio matters only in relation to other currencies. Said another way, if one is investing dollars, there is no direct impact on a portfolio’s performance in a dollar-denominated portfolio with respect to a change in the USD level. For example, Build’s portfolios are USD denominated so there would be no direct currency impact on the portfolio.

Record Levels of Risk Asset Supply & Level of Spreads

The Threat: The large influx of risk asset supply could lead to wider spreads

Another area of concern for fixed income investors has been the proliferation of risk asset supply. These are most notably in the investment grade and high yield bond markets, but also in the supply of loans and the increase in direct credit investing. According to SIFMA[3], on a year-to-date basis, investment grade corporate bond issuance was 87.8% higher than this time in 2019, with approximately $1.3T issue so far. That amount is almost as high as 2017’s record issuance for the entire year. The story in high yield, while not as dramatic, is similar, with year-to-date issuance up ~40% as of the end of July with $224B in new supply. As a result, the concern around supply related to spreads and risk premia for these assets is front and center.

The Outlook: Current market conditions and valuation metrics may offset any saturation effects

While there is no doubt that issuers have embraced the current low yield environment and have opportunistically created supply, the related metrics may give investors comfort. Using the Blomberg Barclays US Aggregate Credit Average OAS as a proxy for investment grade spreads (gold line) and the Bloomberg Barclays US Corporate High Yield Average OAS for high yield (white line), it appears that IG corporates have recovered from the extreme levels experienced in early 2020 but are not near the expensive levels seen in 2018. Similarly, high yield has repriced dramatically since the wide spreads of March but are currently still materially cheaper than the levels seen in 2018 and late 2019 and early 2020[4].

Source: Bloomberg

Suppose one looks at the level of spread (white line) as a ratio to the generic 5-year US Treasury yield (orange line). In that case, the level of spread relative the level of current yield looks very attractive[5]. Taken together, the level of spreads in the context of the current level of interest rates and investment grade supply does not look mispriced. A conservative approach to fixed income focuses on high credit quality with an agnostic approach to duration, making risk management a priority. If corporate supply increased to an extent it was adversely effecting credit spreads, active management allows for rotation out of risk assets into more liquid, highest quality government bonds.

Source: Bloomberg

 

Low Yields, Lack of Income and the End of the Bull Market in Bonds

The Threat: Fixed income won’t provide increasing returns

For some time now, global interest rates trends have been low by virtually any measure. Below, note the sawtooth pattern towards lower yields over the last 20 years, with the U.S. (white line), Germany (gold line), Canada (purple line), and Japan (red line) all trending down[6]. While there is no singular, definitive explanation for this, some of the reasons to help explain it include fiscal and monetary policy changes, shifts in the term risk premium and inflation expectations of investors, and the recent de-leveraging from the great financial crisis[7].

Source: Bloomberg

Whatever the reason for the declining rates, it presents fixed income investors with a dilemma: Do I remain in an asset class with price appreciation, but that will continue to give me less and less income?

The Outlook: There are many ways to increase returns without losing downside protection

Concerning the issue of lack of income available to fixed income investors, the reality is it simply isn’t there. Since cashflow from fixed income instruments is associated with coupon payments and coupons are set relative to the overall level of yields, those coupons are also low. There are only a couple of ways to increase that level of income or coupon. One is to take on more credit risk, a high-risk move to make as we are in the late stages of the credit cycle, and therefore credit “events” become likely. The other is to extend duration when the yield curve is positively sloped – fine to do if you believe the yield curve will flatten or rates will continue to grid lower. But as mentioned earlier, Build’s strategies allow investors to own a bond portfolio of very high quality and avoid reaching for too much risk. The long-only equity call options allow for participation in upside equity movement, creating potential capital appreciation, while limiting the downside to the price of the option premiums paid. This total return approach can help investors make up for lack of cash flow from fixed income.

Additionally, if investors are concerned about rates being too low and the end of a bull market in bonds, an extension in duration is likely a bad move. Perhaps the simple, unfortunate answer is that indeed, fixed income does, and will continue to, produce deficient levels of income. Still, the solution to that problem is not to reach lower in terms of credit profile or extend duration.

In terms of the end of the bull market in bonds, it is simply unknown. This narrative has been in the market for years and yet, bonds continue to rally. That may be because bonds are not simply about yield or income. The total return on investment matters. This total return is measured not only from the income a bond provides, but also the price appreciation. That is why the response to investors who say, “why would I buy a German government bond with a negative yield?!” Is, “because it can go more negative and achieve a higher price.” Investors should always have at least some fixed income exposure since it is useless to try and predict the cycle of interest rates. By having risk-based interest rate exposure, an investor will have the opportunity to participate in the price appreciation and total return of fixed income instruments.


While it is prudent to be mindful of low rates, possible inflation, and other issues confronting fixed income, there are ways to mitigate their effects. To remove oneself from the opportunity set fixed income provides is merely taking a return lever out of the investors’ toolbox. At Build, the active management of fixed income and the addition of the equity options overlay is critical to provide the anchor in the investor’s portfolio. It is a conservative approach with a risk-mitigation implementation. Build recognizes that a fixed income investor’s outcome is largely driven by duration and credit management, but it also allows for a risk-controlled upside participation in the equity market with a quantifiable downside. As such, our primary function given today’s fixed income market is to ask bonds to act as the stabilizer while the equity options overlay seeks to replace the traditional yield component most fixed income investors hope for. In Build’s view, this is a safer bet than stretching for yield or duration currently. Hence, making Build’s Indexed Risk Control concept an attractive alternative to traditional fixed income, especially given investor’s valid concerns in the traditional fixed income space.

Foot Notes
[1] Board of Governors of the Federal Reserve System

[2] Bloomberg

[3] US Corporate Bond Issuance

[4] Bloomberg

[5] Bloomberg

[6] Bloomberg

[7] Council of Economic Advisers, President Barack Obama

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