How to Approach Bond Portfolios in a Post-Post-Crisis World | American Funds

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Mike Gitlin Head of Fixed Income
David A. Hoag Portfolio Manager
Margaret H. Steinbach Investment Specialist
investment perspectives

Bond Portfolios in a Post-Post Crisis World

Key Takeaways

  • Markets are in a “post-post-crisis period” characterized by low interest rates and subdued economic growth.
  • Fixed income investors should consider owning duration, but avoid undue credit risk from bond funds stretching for yield.
  • Diversified fixed income portfolios can still generate 3% to 4% annually without taking equity-like risk.

Markets entered a new phase in late 2014 as the Federal Reserve took its first step toward normalizing policy. What separates this most recent environment from the prior period immediately following the financial crisis is the fact that, despite ongoing global central bank easing and accommodation, the macroeconomic backdrop and financial markets seem to be experiencing diminished benefits.
 

Three Distinct Periods in Fixed Income Evolution After Risk-Off and Risk-On Periods, the Total Return Outlook Is More Benign

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Sources: Bloomberg Index Services Ltd., RIMES. As of June 30, 2017.

During the present economic phase, as central banks continue to keep interest rates low and are buying local bonds at an unprecedented pace, global economic activity and inflation remain modest. What’s more troubling, diminished returns are being produced in the context of heightened uncertainty and volatility. We call this the post-post-crisis period. Investors should consider several principles to invest in fixed income during this new phase:

 

1. Don’t Be Afraid to Own Duration

We expect rates to remain low for a lot longer. The United States’ relatively healthier trajectory compared to other major economies does not necessarily mean rates will rise meaningfully in the coming years. The Fed’s path to normalization will remain very gradual and will continue to respond to the strength of the U.S. dollar as well as unforeseen developments in the U.S. and abroad. Investing in core fixed income as part of a balanced portfolio is a crucial need in today’s unprecedented, uncertain environment.

Interest Rates Can Stay Low for a Long Time

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Sources: Federal Reserve, Thomson Reuters Datastream. As of June 30, 2017.

2. Watch for Scope Creep

The persistent low-interest-rate environment post-crisis has dramatically changed investment manager behavior. Seven years at the lower bound of interest rates has incentivized managers to reach further out on the risk spectrum in order to find higher yields and better return potential.
It’s for this reason that many core fixed income funds hold significant amounts of high-yield bonds today. While this behavior was rewarded in the low-volatility, risk-on market dynamics of the post-crisis era, fixed income portfolios invested in this way will be too highly correlated to the equity market to be considered “core fixed income,” in our opinion. This is because high-yield bonds exhibit a strong positive (+0.8) correlation to the equity market.

Comparing Unconstrained to Core Bonds During Recent Equity Market Turmoil*

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Sources: Bloomberg Index Services Ltd., Morningstar. Correlation data as of June 30, 2017, based on monthly returns.
* Unconstrained bond funds can be found in the Multisector and Nontraditional Morningstar categories.

While many financial advisors tend to focus on historical returns and fees in selecting managers, we suggest including a filter for equity correlation as well. In times of volatility, it’s exceedingly important to invest in bond funds that behave like bond funds. Specifically, core fixed income investments should lower overall portfolio return volatility and serve as the anchor to a balanced portfolio in times of equity market stress. Protecting your portfolio against potential equity market volatility is especially important when considering equities are in their eighth year of a bull market despite a more recent struggle in corporate earnings growth.


3. Tax-Exempt Bonds Are Not Just About Taxes

Currently, the tax-equivalent yields on municipal bonds are meaningfully in excess of their taxable counterparts. In addition to their tax advantage, though, tax-exempt bonds possess additional attractive qualities that enable them to add value to a core fixed income portfolio. Tax-exempt funds have not only demonstrated low historical correlation to the equity market but can also provide diversification in terms of return sources.

Because tax-exempt bonds are issued by state and local municipalities, they are largely insulated from the global dynamics that have recently caused volatility in the taxable bond and equity space, including concerns about China and the strong U.S. dollar.


4. Aim for 3% to 4% Yields on Fixed Income Portfolios

With today’s lower total return expectations, we believe a diversified portfolio that yields 3% to 4% is achievable without taking on undue equity-like risk. With the Bloomberg Barclays U.S. Aggregate Index yielding just 2.0% today, one might be tempted by a large allocation to high-yield bonds in order to achieve that 3%–4% yield target. While some allocation to the high-yield market is warranted given its income profile, high-yield bonds exhibit a strong positive correlation to the equity market.

For that reason, we believe high-yield bonds should occupy only a small position in a fixed income portfolio or even be viewed as part of an individual’s equity allocation. Rather, we would suggest including allocations (in taxable accounts) to municipal bond funds as the way to pursue a higher portfolio yield, as municipal bonds can offer attractive tax-equivalent yields in excess of core taxable strategies.

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