As we ride out the storm of Covid-19, many investors are tabulating lessons learned, as well as the differences and similarities with past episodes of acute market stress. With interest rates having dropped so low and government balance sheets having been stretched so significantly to stimulate global economies, how should they be thinking about the role of core fixed income (CFI) going forward? Is it “different this time?” Is it the “same as it ever was?”
The Covid-19 shock is unprecedented in many ways. But when we analyze the behavior of asset classes during historical periods of equity market drawdowns, we can see that core fixed income has exhibited strikingly similar characteristics over many decades of crises. We believe it is not different this time.
In our approach to portfolio construction core fixed income refers to lower volatility fixed income assets—for example, investment grade fixed income--intended for risk management. Institutions may hold these assets of specific maturities to match their liabilities; individuals may hold them as “sleep-well money.” This definition allows us to clearly distinguish these fixed income assets from the higher volatility fixed income satellites, such as high yield bonds (Exhibit 1), which are intended to provide long-term growth in portfolios. There are, of course, fundamental differences between these two groups; not all fixed income assets are created equal.
Policy rates are set to be in lower for longer, with the Federal Reserve (Fed) explicitly mentioning that they are “not even thinking about thinking about rate hikes.1” As of July 22, 2020, Fed fund rate projections show a perpetuation of the status quo well into 2022. While in the near future we are not likely to see interest rates climbing back up to the levels last seen a decade or two ago, we think CFI will retain its role as a key strategic, risk-managing tool within portfolios, offsetting the effects of more volatile assets during crisis. As we will demonstrate, to the surprise of some, this property appears unrelated to the starting level of interest rates.
Source: Bloomberg and GSAM, as of June 30, 2020.
In Exhibit 2, which includes data beginning in 1989, we study the relationship between fixed income total returns during equity drawdowns, which are defined as at least a 5% peak-to-trough movement for the S&P 500. We analyze several investment-grade bond categories, including the Bloomberg Barclays US Aggregate Index, US Treasuries at different maturities, and US mortgage-backed securities, all typical components of a core fixed income allocation, as well as US high yield bonds, which fall into the satellite fixed income category.
Proceeding from left to right on the chart, the first sets of vertical points correspond to fixed income total returns during the most severe S&P equity drawdown in recent history: the 2008 Global Financial Crisis. Between September 2007 and September 2009, the S&P 500’s value was more than halved (-55%), while US high yield bonds were down approximately 29%. Yet all the CFI assets we examined delivered a positive return during those very uncertain times, and in some instances very comforting returns.
The second set of vertical dots represents the -49% S&P drawdown corresponding to the Dot Com bubble collapse from March 2000 to September 2002. Here we also observe the same pattern of fixed income returns, with negative performance for high yield bonds and positive performance for CFI assets.
As we continue to move to the right portion of the chart, the data gets busier, as there have been more frequent instances of moderate equity drawdowns. But looking at the trend lines, we continue to observe that CFI assets have done an excellent job in behaving differently than risky, return-generating assets like equities and high yield, delivering positive performance during challenging times.
As we move into an environment characterized by “lower for longer” interest rates, one might expect CFI assets to provide less of an offset against equities and other riskier assets since bond yields have less room to rally as they approach zero. While we understand the view that higher yields might provide a bigger buffer during periods of mounting risk aversion, we don’t think that low yields on CFI assets mean they will lose their ability to mitigate overall portfolio risk.
Source: Bloomberg and GSAM, as of June 30, 2020. Past correlations are not indicative of future correlations, which may vary.
Despite decreasing yields, Exhibit 3 above shows that correlations between equity and investment-grade fixed income returns not only have remained negative, but actually have been trending lower. Even in a more challenging yield environment, core fixed income continues to play an essential role in portfolios, helping to sustain performance exactly when help is needed most.