This year has shown us that no matter how hard we try, we can’t predict the future. But as rational investors, we should do our best to prepare for it. At GSAM, when it comes to portfolio construction we continuously emphasize preparation over prediction, and preparation has to start by looking at—and taking appropriate care of—your portfolio’s core.
Developed market bond yields are near or at record lows and may stay there for years. This has many in the investment community pointing to the evolving role of bonds in portfolios and more specifically to the assumed—and, we believe unfounded—belief that holding bonds in a balanced portfolio is no longer wise.
From a return-generation standpoint, no one can argue against the arithmetic of a negative yielding bond: if bought at issuance and held to maturity it will incur a capital loss. Nevertheless, the term “bond” encompasses a huge variety of diverse asset classes with very different attributes.
In other words, not all fixed income is created equal. In our approach to portfolio construction, core fixed income (CFI) refers to lower volatility fixed income assets—for example, investment grade fixed income—intended primarily for risk management and drawdown mitigation in periods of acute market stress. This definition allows us to clearly distinguish these assets from higher volatility fixed income satellites, such as high yield bonds, that are intended to provide long-term growth in portfolios.
What did we learn from the recent COVID-19 induced equity bear market? X-raying the behavior of equities and government bonds at different maturities for various countries reveals how CFI continues to play a key role in managing risks and mitigating drawdowns (Exhibit 1)—even in today’s low rate environment.
Source: Bloomberg and GSAM. Analysis as of October 23, 2020. Yields represent the performance of the country’s sovereign bonds at different maturities. The equity indexes analyzed are: S&P 500 Index for the US, FTSE 100 Index for the UK, DAX Index for Germany, and FTSE MIB Index for Italy. Please see disclosures for the full list of indexes. Rating indicates the country’s sovereign credit rating according to Moody’s rating classification, as of October 23, 2020. For every country the drawdown periods consider the performance from the previous peak in index value to its consequent trough. For the US, Germany, and Italy the period analyzed is from 2/19/2020 to 3/23/2020; for the UK, 1/17/2020 to 3/23/2020. Past performance does not guarantee future results, which may vary.
In Exhibit 1, we analyze the performance of equities compared to government bonds at different maturities. For example, on the left hand side we look at the US and show the return of the S&P 500 (-33.8%) from February 19, 2020 to March 23, 2020, corresponding to the previous market peak and consequent trough. Over the same time horizon we then show returns for Treasuries at different maturies and we repeat this analysis for Germany, the UK and Italy. Here’s what we found:
First, duration matters. Allocating to higher duration bonds generally increases the yield, which may increase risk mitigation during drawdowns. This point is clearly shown in Exhibit 1 by looking at the US or the UK. However, over-allocation to higher duration bonds or to ultra-long maturities also adds interest rate sensitivity, and potential downside risk to performance, once the economic environment improves and rates begin to increase.
Second, negative yielding sovereigns (in Germany, for example), still offer downside mitigation. Returns on these bonds were approximately flat while German equities sold off almost 39% in just over a month. Of course, with negative yielding bonds, the math is no longer in our favor and calls for tempering our expectations accordingly. In those cases, cash may begin to play a bigger role in portfolios.
Finally, credit risk matters, as it has an impact on the degree of risk mitigation a sovereign bond can offer during equity drawdowns. In general, the lower the credit rating, the lower the mitigation offered. In exhibit 1 we show Italy (Baa3) as an example, but a similar story may be drawn for countries with similar credit risk profiles. In addition to sovereign rate risk, it’s also important to consider corporate credit risk. For example, Exhibit 2 shows the returns over the same period for different segments of the US corporate bond market, and it is clear to see that the lower rated segments were less helpful in mitigating drawdowns. This should come as little surprise, as lower rated bonds tend to be more correlated to equities. As a result, while the US corporate bond market is defined as investment-grade, expectations for the index should be adjusted accordingly, and corporate bond exposures may need to be more tailored to an investor’s tolerance for loss.
Source: Bloomberg and GSAM. Analysis as of October 23, 2020. Please see disclosures for the full list of indexes. Past performance does not guarantee future results, which may vary.
The takeway here, as we see it, is clear: in periods of acute equity market stress, core fixed income continues to play an essential role in managing risk and mitigating portfolio drawdowns. This remains so even in today’s challenging yield environment. It’s also important to remember that the CFI category is a broad one, composed of different asset classes that greatly vary when it comes to yield, duration and credit risk.
We believe the current high volatility environment is here to stay, making it important to prepare portfolios for what may lie ahead. In our view, a great way to start is by taking more care of your portfolio’s core.