A New Era for Fixed Income Investments By Justin Pawl, CFA, CAIA, CFP®

I’m not an American football historian, but I suspect no college or professional football team has ever won a championship that didn’t have decent teams on both the offense and the defense. No matter how good a team’s offense, the defense must stop the other team from scoring at least once to win a game. Good defense also makes offense easier through better starting field position. The same “formula for success” holds for investment portfolios, where good defense in a crisis protects capital and creates an optimal starting point for reallocations (buying low, selling high). However, a reliable member of the traditional portfolio allocation’s defense is hobbled.

COVID-19 simultaneously reduced return expectations and increased the fragility of traditional 60/40 portfolios. Of course, it wasn’t the virus itself, but rather measures taken by

“Defense wins championships.”University of Alabama Football Coach Paul “Bear” Bryant

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global central banks to combat the effects of the pandemic lockdown to prevent a global depression. In the U.S., the Federal Reserve reduced its target rate's lower bound from 1.25% to 0% in March. The Fed also took additional actions to ensure credit markets continue functioning normally and that interest rates remain low through unconventional measures. Just as the Fed went beyond traditional monetary policy tools to address the pandemic, investors should consider expanding their Investment toolbox beyond conventional equity and fixed-income holdings to reduce the impact of another catastrophic stock market decline. Given our starting point, investing for the future just became a lot more difficult. The purpose of this memorandum is to explore the consequences of low interest rates on portfolio construction and to suggest options to effectively allocate capital for the future.

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Before delving further into this topic, if you believe that domestic stock markets will generate similar returns to what they've offered over the last ten years (10.6% annualized), then you can stop reading this missive. Because if that is your forecast, you shouldn't care about your fixed- income allocation as equity performance will more than compensate for the lower interest rates. However, in considering how confident you are in that view, you should contemplate the chart below. This chart illustrates the historical rolling

For more than 60 years, bond yields in the U.S. had remained comfortably above 0% and, as such, bonds lived up to their dual mandate more often than not. Moreover, during the last 30 years bond investors enjoyed an added benefit of capital appreciation as interest rates declined from 16% (1980s) to around 2.5% following the Great Financial Crisis in the 2010s. Then, more recently, the COVID crisis pushed 10-year yields down below 1%, adding more upside to bonds than many thought possible.

Historically, government bond investments have served two roles in diversified portfolios:

1) Provide portfolio income AND 2) Act as a hedge to equities in the event of economic stress.

A NEW ERA FOR FIXED INCOME INVESTMENTS

If Equities Provide More Return Over Time, Why Invest in Fixed Income at All?

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10-year performance of the venerable Dow Jones Industrial Index going back to 1909. The rolling 10-year performance ending 12/31/2019 is nearly one-standard deviation from the index’s average over the 110 years. For those who aren't statistically inclined, data points within a universe of observations only exceed +1 standard deviation 15.6% of the time. To be clear, equities could continue to perform well above their historical average, but the odds are low.

Sources: Bloomberg and Covenant Investment Research

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In all but one of the bear markets, bonds reduced portfolio volatility by offsetting equity losses. In each of the scenarios (with the exception of the First Gulf War) investors purchased bonds at a time when the Federal Reserve had room to reduce its target interest rate to mitigate economic weakness and bonds rallied when equities declined. The COVID crisis was no different, although bond yields started from a lower level. When the S&P 500 declined by 34% from February 19 through March 23, the 10-year government bond appreciated by 7.8%, as the Federal Reserve cut rates to the zero boundary, and the yield on 10-year bonds declined from 1.6% to 0.8%. In a 60/40 portfolio, the equity allocation contributed -20% to performance, and bonds added 3%, resulting in a total portfolio decline of approximately -17% during this

timeframe. Because rates were already low, government bond performance lacked the "oomph" of previous rate-cutting periods, but at least they offered something.

Today, however, the target rate is already zero, and the Federal Reserve has indicated it has no intention of reducing interest rates into negative territory. Hence, it stands to reason that at these levels 10-year bonds will not benefit from Federal Reserve policy, placing U.S. investors in a similar position to Swedish, Japanese, German, and Swiss investors coming into the pandemic. Illustrated in the table on the following page, when short rates were already close to zero, 10-year sovereign bonds provided a negative return during the COVID market crisis.

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The Good Ol’ Days

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However, the long tailwind of capital appreciation came at a cost that all investors will pay going forward. The first bill coming due is that bond yields are now lower than the rate of inflation. Although inflation is low, it’s rising at a rate higher than the 0.90% you can earn on a 10-year Treasury. Hence, an investment in 10-year bonds loses money on an inflation-adjusted (aka, “real”) basis. In other words, every dollar allocated to the safe portion of a traditional portfolio is eroding the value of the total portfolio. This is a reality that investors must acknowledge in determining how they allocate their portfolio assets. The second cost is that at low starting yields, bonds’ role of hedging equities is constrained and comes

with potentially damaging asymmetric risk (explained below). In sum, traditional portfolio allocations are more fragile than at any point in the modern financial era.

When it comes to hedging equity risk, government bonds have been a reliable foil. The following table illustrates the yield of the 10-year UST at the beginning of each market crisis, along with the total return in the six bear markets since the 1990s.

Sources: GMO, Bloomberg, Covenant Investment Research

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What’s the Solution?

Investors are facing a conundrum. Suppose there is another crisis while rates are where they are today. In this case, fixed income will offer only a modest offset to equity losses as the Federal Reserve has already taken their target interest rate to 0.0%. However, if interest rates rise between now and the

To resolve the thorny allocation issue of negative real yields and low interest rate starting points, investors should first consider what they can realistically expect from traditional fixed-income investments going forward. Investors must then determine how to build a portfolio allocation that meets their long-term financial goals while balancing the risk of large stock market declines. And, investors must do all of this in the context of current market conditions where government bond fixed-income allocations can no longer provide suitable yield and suitable downside protection simultaneously.

Because of this paradox, investors should view the role of fixed income differently than they have historically. Today the yield on the Barclays

Aggregate Bond Index, a benchmark for debt in the U.S., is only 1.2% annually. Many don’t recognize that the Barclays Agg is not a riskless investment like government bonds. Treasury bonds comprise only about 50% of the Barclays Agg. The rest of the benchmark consists of Corporate and Securitized debt, introducing significant credit risk into the benchmark and strategies that track it. During the Pandemic drawdown, the credit risk showed up when the Barclays Agg declined -2.6% in mid-March, contributing to equity losses in a portfolio rather than offsetting them. And even with the additional credit risk, the yield is below the current rate of inflation. Rather than view fixed income as a catch-all solution for risk management and income generation, investors need to define which role they will prioritize and then look to non-traditional sources to fulfill the other role.

next market crisis, while fixed income can offer a greater offset in the future, investors will experience capital losses on their fixed-income investments until that point (when yields rise, the price of traditional fixed-income investments decline).

Source: GMO

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For investors that want to increase the yield in their investment portfolios and simultaneously increase protection, there is a path forward. However, this path requires that investors rely on credit-oriented strategies for yield and “long volatility” strategies for protection. Long volatility strategies tend to perform best when markets are in disarray, and financial risk is high.

Definitionally, “long vol” can be thought of as strategies that tend to perform well when the volatility of instruments they trade rise. A simple representation of volatility is the VIX, an index that measures the market's expectation for 30-day forward-looking volatility (i.e., the magnitude of directional changes) of the S&P 500. When the VIX Index is rising, equities are typically declining (and vice-versa). Sharp moves in equity markets generally result in pronounced VIX movements. For example, in the first quarter of this year, when equities declined by more than 30%, the VIX Index rose by more than 300%. The table below expands on the previous “Bear Market” performance table to include the change in the VIX Index during each of the six market declines.

• Prioritizing Yield: Investors wishing to maximize yield from their fixed income allocation will be forced to take on more credit risk. There’s simply no other way in today’s market environment. Whether that credit risk comes in the form of publicly-traded investment-grade corporate debt, high yield debt (aka, “junk bonds”), or private lending sources, in a significant market downturn, investors should not expect the holdings to rise in value. Instead, the investments' value will likely decline (hopefully to a lesser degree than equities), leaving portfolios susceptible to higher volatility.

• Prioritizing Protection: Mathematically, in the absence of negative interest rates, investors cannot count on government bonds to offer a lot of downside protection. From today’s starting point, if the 10-year bond went to zero instantaneously, it would rise in value by about 6%; if rates fell to zero over a 12-month timeframe, the gain would be closer to 5%. There’s just not that much juice left in 10-year bonds given today’s starting yields. Investors could move further out the yield curve and invest in 30-year bonds, which would offer more downside protection (and slightly better yields). Still, in doing so, they are taking on significant interest rate risk that will result in capital losses if interest rates rise. Investing in riskless U.S. government bonds presents a significant opportunity cost (negative real yields) paired with the asymmetric risk that

interest rates can increase a lot more than they can fall.

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Expanding Your Investment Toolkit

Sources: GMO, Bloomberg, Covenant Investment Research

While the VIX Index itself is uninvestable, there are strategies that trade derivatives on the VIX Index. These long volatility strategies come in various types, and it's beyond the scope of this memorandum to discuss each of them. Of course, as with all investments, there is no guarantee that any specific long volatility strategy will perform well just because equity markets are declining. That is to say, long volatility strategies are not an insurance policy. But isn't it better to allocate a portion of your portfolio to an investment that at least has a chance at adequately protecting your portfolio when markets fall, rather than rely on the paltry potential performance from bonds (which are also not guaranteed to rise in price during periods of equity market dislocations)?

Covenant is well-versed in in both long volatility and income-oriented credit strategies, and for those interested, we can discuss the pros and cons of adding these “non-traditional” strategies to your portfolio. While your portfolio may move differently than you’re accustomed to, integrating long volatility strategies with non-traditional fixed income, can improve the overall returns of a portfolio when compared to following traditional portfolio allocations with interest rates near historic lows.

The investment path ahead promises to be challenging, but there are tools available to make it less so.

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