Today's Fixed Income Frontier
Adapting to the New Landscape
In the wake of the financial crisis, the fixed income marketplace has undergone a significant transformation. For investors, the ability to adapt to the new landscape may be the key to survival – or, at the very least, the key to investment success.
There is a new frontier to contend with in the fixed income space, and BlackRock believes investors should be prepared to spread their wings and make some adjustments to their portfolios in order to soar in this new paradigm.
Not So Long Ago, Treasuries Reigned
During the throes of the economic and financial crisis, investors fled higher-risk assets and moved most of their fixed income investments into very safe vehicles, such as US Treasuries. However, as the crisis abated and the economy started to recover in 2009, the spread sectors of the fixed income market (i.e., bonds other than US Treasuries, such as investment-grade and high-yield corporate bonds, international bonds and securitized assets) enjoyed sizable gains. These types of bonds come with greater risk than US Treasuries and, for that very reason, offer investors a higher yield (a bigger reward, if you will). The difference in their yield and that offered by a Treasury bond with a similar maturity is known as the spread, thus accounting for their street name, "spread product."
While Treasuries reigned supreme amid the hardship, going forward, we believe their relatively low yields will be insufficient for the needs of most fixed income investors. As a result, investors will need to look to diversified bond strategies that include several different types of spread assets in an effort to enhance returns in their fixed income portfolios.
A New World Order
As part of its efforts to help stabilize the economy and provide liquidity to financial markets during the crisis, the Federal Reserve extended guarantees to various types of non-government debt (in effect turning them into government- backed debt) and purchased a massive amount of mortgage-backed securities from Fannie Mae, Freddie Mac and Ginnie Mae. These steps, together with the enormous amount of Treasuries issued by the US government to fund the stimulus package, caused the total amount of Treasuries and other government-backed debt to increase from roughly 25% of the total investment-grade bond market in 2007 to 75% today. As a result, the fixed income market has become dominated by lower-yielding government securities.
These developments have implications for the Barclays Capital US Aggregate Index, a widely accepted representation of the entire investment-grade US fixed income market. Like the market itself, the Barclays Agg has become highly skewed toward government-backed debt and may no longer be an appropriate benchmark for investors. An investor holding a bond fund that attempts to mirror the Barclays index may be insufficiently diversified.
Opportunity in Spread Assets
Maintaining some exposure to Treasuries and government-back debt is important. But in light of the new fixed income landscape, investors who are overly cautious and track the Barclays index too closely may be positioned too conservatively and run the risk of "under earning" investors with a more diversified bond portfolio.
At BlackRock, we believe a meaningful allocation to high-quality spread sectors makes sense in the current environment. Government support of the financial markets has provided stability and bolstered investor confidence, and improving economic indicators and stronger corporate earnings provide a favorable backdrop for improving credit fundamentals.
While it will be difficult for spread assets to repeat the strong outperformance exhibited in 2009, attractive opportunities still exist. With short-term interest rates anchored near zero, the appetite for higher-yielding assets remains strong at a time when net new supply of such assets is limited. The low supply comes from the fact that corporations are issuing less debt and there is a reduction in the amount of new debt coming out of the securitized debt markets. At the same time, spread sectors are undervalued as spreads remain high (and consequently prices remain low) relative to their historical averages versus US Treasuries.
In addition, the yield curve, which is near historic highs in terms of steepness, is likely to flatten as the economic recovery continues and once short-term rates start to rise. Spread sectors have typically outperformed Treasuries during previous recoveries and at times when the yield curve flattens, a phenomenon we expect will be repeated in this cycle.
All of this bodes well for spread assets. However, given their strong run, returns going forward likely will be determined less by overall sector performance and more by individual security selection. As a result, in-depth research remains critical in distinguishing between top and bottom performers within sectors. BlackRock believes investors would be well served to look to active managers with strong credit research capabilities that can identify promising credits in today's increasingly bifurcated and complex fixed income markets.
Diversification Still King
While much has changed, one thing remains the same: Diversification is still critically important in managing portfolio risk. This is true across asset classes, but within asset classes as well.
As illustrated below, no single fixed income asset will be the best performer year after year, as volatility has and will always exist. As a result, investors should cast a wide net in developing a diversified fixed income portfolio. One way to do so may be through a multi-sector bond fund, which typically will have a higher allocation to spread assets than a fund that mirrors a traditional market index.
Working with a professional investment manager can be an asset here as well. As market conditions change, an active manager has the expertise to actively rotate out of those sectors that are relatively overvalued and into those that are undervalued in an effort to capture the maximum upside opportunities while at the same time limit downside risk.
The Case for Active Management in a Changing Market
Calendar Year Fixed Income Total Returns by Sector
Sources: Barclays Capital. Reference Indices: Emerging Markets – Barclays Capital Emerging Markets Bond Index; High Yield – Barclays Capital US Corporate High Yield Bond Index; Non-US Government – Barclays Capital Sovereign Index; Investment-Grade Corporate – Barclays Capital US Corporate Bond Index; Agency Mortgage-Backed Securities (MBS) – Barclays Capital US MBS Index; Aggregate – Barclays Capital US Aggregate Bond Index; Commercial Mortgage-Backed Securities (CMBS) – Barclays Capital CMBS Index; US Treasuries – Barclays Capital US Treasury Index; Asset-Backed Securities (ABS) – Barclays Capital US ABS Index. Past performance is no guarantee of future results. It is not possible to invest directly in an index.
The two main risks related to fixed income investing are interest rate risk and credit risk. Typically, when interest rates rise, there is a corresponding decline in the market value of bonds. Credit risk refers to the possibility that the issuer of the bond will not be able to make principal and interest payments.
* Archived articles are current as of the original date of publication.