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A popular asset allocation call of 2018, saw over $70bn flow into the Morningstar Ultrashort Bond category.1
In 2018 the overarching market view was that the Fed would continue its rate-hiking cycle well into 2019, based on underlying economic strength and relatively hawkish language from Fed Chairman Jerome Powell.
As a result, many investors chose to reduce duration in their portfolios by moving into ultra-short assets — a common approach in a rising interest rate environment.
2019 tells a different story, as market expectations for rates continued to shift downward for most of the year.2 (See Figure 1).
As such, fixed income decisions made last year in a rate-hiking environment, warrant a rethink in our opinion.
OVERNIGHT INDEXED SWAP
The overnight index swap denotes an interest rate swap involving the overnight rate being exchanged for a fixed interest rate. An overnight index swap uses an overnight rate index such as the federal funds rate as the underlying rate for the floating leg, while the fixed leg would be set at a rate agreed on by both parties.
In reviewing fixed income allocations, we think it is important that investors remember two of the primary reasons behind investing in the asset class; namely, diversification from equity risk and income generation.
Even in a rising rate environment, the income component paid out by intermediate-term bonds may help mitigate the price impact from rising yields. Generally speaking, bonds with longer durations have a higher yield (risk free rate plus credit spread) and therefore generate a higher degree of income. This is reflected in the outperformance of intermediate-term fixed income category versus ultra-short fixed income on a total return basis over the past 15 years. (See Figure 2.)
A risk-adjusted measure of returns calculated by using standard deviation (performance volatility) and excess return to determine reward per unit of risk. The higher the Sharpe Ratio, the better an asset’s historical risk-adjusted performance.
A drawdown is a peak-to-trough decline during a specific period for an investment or asset. The average drawdown is calculated as the average yearly maximum decline over the period.
Additionally, over the same time period, intermediate-term fixed income has delivered greater diversification benefit from equity volatility compared with ultra-short fixed income, particularly in down markets.
It is not our base case that we are heading towards an imminent recession and/or further Fed rate cuts. But, we believe the U.S. economy is slowing to around trend growth, which over the past decade is growth of around 1.9% per year.4
However, if the Fed continues its policy easing then having duration exposure in fixed income allocations could provide an important source of ballast against potential equity market volatility. (See Figure 3.)
A statistic that measures the degree to which two variables move in relation to each other. A negative number shows two assets have historically moved in the opposite direction, while a positive number shows they have historically moved in the same direction at the same time.
There may be a number of reasons investors moved into ultra-short duration products last year. But if it was to shelter from rising interest rates — a thesis that no longer holds merit —then we believe now is the time to revisit that decision.
1 Source: Morningstar as of December 31, 2018.
2 Source: Bloomberg as of March 20, 2019.
4 Source: Trading Economics as of December 31, 2018.
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Bonds are subject to interest-rate, credit, liquidity, call and market risks, to varying degrees. Generally, all other factors being equal, bond prices are inversely related to interest-rate changes and rate increases can cause price declines. High yield bonds involve increased credit and liquidity risk than higher-rated bonds and are considered speculative in terms of the issuer’s ability to pay interest and repay principal on a timely basis. The use of derivatives involves risks different from, or possibly greater than, the risks associated with investing directly in the underlying assets. Derivatives can be highly volatile, illiquid, and difficult to value and there is the risk that changes in the value of a derivative held by the portfolio will not correlate with the underlying instruments or the portfolio’s other investments.
S&P 500 Index: The S&P 500 is an index designed to track the performance of the largest 500 US companies.
Bloomberg Barclays US Aggregate Index: The Barclays U.S. Aggregate Index is a widely accepted, unmanaged total return index of corporate, government and government-agency debt instruments, mortgage-backed securities and asset-backed securities with an average maturity of 1-10 years.
ICE BAML 1-3 Month US Treasury Index: The BofA Merrill Lynch 1-3 Month US Treasury Index is an unmanaged index that tracks the performance of the direct sovereign debt of the U.S. Government having a maturity of at least one month and less than three months.
Bloomberg Barclays US High Yield 2% Issuer Cap Index: The Bloomberg Barclays US High Yield 2% Issuer Cap Index is an issuer-constrained version of the flagship US Corporate High Yield Index, which measures the USD-denominated, high yield, fixed-rate corporate bond market. The index follows the same rules as the uncapped version, but limits the exposure of each issuer to 2% of the total market value.
Credit Suisse Leveraged Loan Index: This index tracks the investable market of the U.S. dollar denominated leveraged loan market. It consists of issues rated “5B” or lower, meaning that the highest rated issues included in this index are Moody’s/S&P ratings of Baa1/BB+ or Ba1/BBB+.
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