Content provided by Josh Jenkins
Q: About a year ago, analysts predicted the bull market in bonds was over. But today, CLS says it is still intact. What changed?
Going into 2014, I think the expectations on Wall Street were definitely for an increase in interest rates moving forward. During 2013, when the Fed began to discuss tapering their QE program, you saw a really large jump in rates. And then, when the QE program ended in December, I think the basic expectation was that the logical next step was for the Fed to increase its benchmark rate. So, with the momentum of the rates increasing and then the expectation of the rate hike—it was a consensus view that rates would continue to move up.
People have been trying to call an end to the bull market in bonds for quite some time. But it doesn’t seem to be ending when you look at some of the recent market action—for example, this month the yield on the 30-year Treasury hit all-time lows. The prices on bonds and yields move in opposite directions so when yields come down, that means prices are going up. So, with the all-time low yield, that means the prices are still doing very well. It would definitely be premature to call ‘time of death’ on the bull market.
Q: Despite this continued bull market, CLS believes long-term prospects for bonds still don’t look great. Why not?
There are a lot of different factors that are going to affect the prices for bonds—obviously interest rates are one. Another important one, which can easily be overlooked, would be the credit aspect of bonds. That is, the risk that the bond issuer is not going to be able to pay the principal or interest. Having said that, the largest determinant of bond prices is the overall level of interest rates. And with interest rates essentially near all-time lows, that just doesn’t bode well for prices going forward.
Q: So should investors stay away from bonds?
It’s said that diversification is the only free lunch in investing. Historically, bonds have offered some of the best diversification benefits when combined with an equity portfolio. As an example, let’s look at 2008 when equities across the board, whether domestic or international, large cap or small cap, were down 30% or more during the year. Yet most high quality bonds actually had a positive performance. So overall it can be a benefit to have them in your portfolio.
Q: Because the bond market is down, CLS is looking to actively manage fixed-income holdings. What are the advantages of this approach?
Last year we saw a decent amount of return dispersion in fixed income. The best performing fixed income segment and the worst performing fixed income segment differed by about 6%. I think that provides us with a lot of ability to add value and actively manage our fixed-income exposure for our clients, whether it be managing duration, managing for inflation, managing credit, or even geographically. There’s just a lot of room for us to add value for clients with an active management approach to fixed income.
Q: What are the risks for fixed income that you see?
I think the biggest risk—and the risk that’s definitely going to be on the forefront in the minds of most investors—is going to be rising interest rates. At CLS, we are mitigating this risk by managing our duration exposure. Duration measures a portfolio or bond’s sensitivity to an increase in interest rates. Currently, we’re managing our duration exposure to be below the benchmark. If interest rates moved up, then our portfolios should hold up much better than say, the Barclays Aggregate Index, which is probably the most quoted fixed income benchmark.
A tail risk in fixed income could be the lower-for-longer oil prices; if they drop further or for much longer, it could really hurt the high-yield market, which consists of a large number of energy-related companies. CLS has been increasing the credit quality of its bond portfolio even before the drop in oil prices began, so that should be a positive for those portfolios.
Q: As we talked about, we know the Fed is likely to raise interest rates in 2015. What else can investors do to protect their portfolios?
I would say to just stay the course. We build broadly diversified portfolios here at CLS because we believe a broadly diversified portfolio that is tailored to the risk tolerance of an investor is the right approach. While fixed income is not viewed as ‘sexy’ compared to equities (you’re probably not going to wow your friends with the sweet bond purchase you just made in your portfolio), we think the diversification benefits of bonds can create a net positive for your portfolio regardless of where rates go from here.