What is the role of fixed income in your portfolio? There are two key considerations for fixed income that all investors should understand.
First, fixed income’s role is not diminished by what may be greater hurdles in the future (ie. rising interest rates). When the next downturn comes, we fully expect fixed income to outperform equity assets.
Second, price returns of bonds are not the whole story. Remember, what you glean from a month-end investment statement is only part of the narrative.
How did we arrive at these findings? Let’s take a look at what brought us here.
Background: The Unwinding Process
The financial crisis of 2008/09 in many ways was an atypical recession. As a result, the response to arrest the falling economy by the Federal Open Markets Committee (FOMC) was anything but typical and turned out to be truly unprecedented. After cutting the short-term Federal Funds rate to nearly zero, the FOMC embarked on additional stimulative measures through purchasing bonds in the open market with the Federal Reserve’s (Fed’s) balance sheet to stimulate growth. Known as Quantitative Easing (QE), the FOMC grew its balance sheet from just under $1 trillion in assets pre-financial crisis to $4.5 trillion by the end of 2014 through the purchase of mortgage-backed securities, US agency debt and long-term Treasury securities. To give context to the growth of the Fed’s balance sheet, before the financial crisis the balance sheet represented ~6% of GDP. By the end of QE, the balance sheet represented ~23% of GDP, an unprecedented expansion.
While arguments still rage on if these measures were necessary, we’ll leave those for cocktail parties and address the $4.5 trillion question: What comes next? The Fed has been very intentional with their discussion of the topic. If you’ll recall back in May of 2013, then Federal Reserve Chairman Ben Bernanke announced the Fed would no longer purchase bonds in the open market which subsequently caused a rapid rate rise. The reaction to the Fed’s first attempt to unwind the balance sheet is now affectionately referred to as the Taper Tantrum.
Janet Yellen, who served as Federal Reserve Chair until Feb. 3, 2018, had been clear not to make the same mistake. In June, the outline of how to unwind was floated to the market and on September 20th the Fed officially announced the unwinding process. Starting in October, the Fed began allowing maturing Treasuries to run off by $6 billion per month and plans to slowly increase that number to $30 billion over the coming months. They will employ a similar program for agency debt and mortgage-backed securities starting at $4 billion per month that will build to $20 billion. While billions are not small figures, they are coming off a grand total of trillions of dollars. At the full $50 billion a month pace the Fed’s balance sheet will drop below $3 trillion in 2020. This proposed gradual unwind is widely expected as a path forward but there are a number of uncertainties between now and then. We do not yet know how Federal Reserve Chairman Jerome Powell will approach the situation.
Historical Performance: Yield Benefit Overwhelms Price Impact
So what is the practical impact for bond portfolios? The short answer is bond prices have been under pressure. This should come as no surprise given it has been one of the most commonly discussed fears by market prognosticators over the last few years. The good news is bond math is fairly straightforward on how returns are generated so while the unwind of the balance sheet is unprecedented, we do have a road map for the potential impact on fixed income markets. The price return - the price paid at purchase relative to the price received at maturity or sale - is one component of return. However, there is a second element to return which is the prevailing yield from portfolios. While the downside of rising rates is the potential for lower bond prices, a direct result is also higher yields. Coupon payments and/or principal reinvested at higher rates is accretive to total return despite lower prices on bonds. We showcase the impact on bond returns during sustained periods of rising rates since the mid 1970’s. For comparison, we have separated the impact from price return and the impact from yields.
As you can see from all of these previous periods, bond prices did indeed fall. However, that is only part of the equation. As yields rose, they contributed positively to total return and in all six instances yield benefit overwhelmed price impact. This does not mean bonds are invincible, but the death of bonds may have been greatly exaggerated.
Fixed income plays an important role in portfolios. Rarely is it looked to as the source of return generation, but often as the stabilizing factor when times get tough. As the Fed embarks on the unprecedented unwind of its balance sheet it is likely fixed income may face its own hard times.
However, we ask investors to remember our two key considerations.
- Fixed income’s role in your portfolio is not lessened by the potential for bigger hurdles in the future. When the next market downturn comes, keep in mind that we expect fixed income to outperform equity assets. That is a key consideration for investors who do not have the ability or interest in bearing the full brunt of volatility from equity markets.
- Look beyond the price returns of bonds. Investors may see more volatility and perhaps downward pressure on bond prices. However, keep in mind that higher yields can add meaningfully to total return. This is not an easy ask as price movement can be seen right away on an investment statement whereas yield adds to the portfolio over time. As such, we continue to believe it is wise to consider the long game when addressing the role of fixed income in your portfolio.
If you have questions about the use of fixed income in your portfolio, contact one of our advisors.