Harnessing Fixed-Income Returns Through The Cycle by Columbia Threadneedle Investments
- There are four unique, major fixed-income risks – duration, credit, inflation and currency – and different fixed-income investments respond to them differently.
- Applying a full understanding of the four risks to a fixed-income portfolio may yield a better risk-return outcome.
- A multi-sector fixed-income portfolio based on the four risks may succeed where some binary risk allocation strategies are presently failing.
The fixed-income market has become increasingly complex. Drivers of returns across bond portfolios are less transparent, dashing investors’ return expectations in various environments. Much of this results from bond investors not knowing what they own. By breaking bonds down to their most basic components, today’s investors will gain a better understanding of the factors that generate risk and return. A better understanding of these drivers can help investors navigate the current market and build bond portfolios that can generate attractive returns through the cycle.
Fixed-income asset classes respond to risks differently
It is easy for an investor to misunderstand the risk associated with a fixed-income investment, although this can have significant portfolio strategy implications. A look at the risk composition of some common bond indices is revealing (Exhibit 1). For most domestic, investment-grade indices, an investor should expect most of the risk to come from duration, or interest rate risk. This is not surprising when you consider that the Barclays U.S. Aggregate Bond Index has a large portion of its market value in government-backed debt. However, investors in Treasury inflationprotected securities (TIPS) or investment-grade corporate bonds may be surprised to learn that much of their return is still derived from duration. This is because changes in government bond yields explain a large portion of the return of these high-quality asset classes.
The story changes further down the risk spectrum. Below-investment-grade securities like high-yield bonds and bank loans derive most of their volatility from credit risk. This is because changes in corporate credit metrics and default probabilities account for most of the performance of these sectors. However, some investors may be surprised to learn that duration risk is low in both asset classes despite the fixed-rate nature of high-yield bonds versus the floating-rate nature of bank loans. In international markets, currency risk drives a significant portion of the volatility profile. In fact, currency risk explains more than half of the performance volatility of the Barclays Global Aggregate Index.
Before we can get into strategies for building better portfolios, we first need to review the major types of risk factors that drive fixed-income performance.
What is a risk factor?
A risk factor is an independent market variable that helps explain the return of an investment. It’s important to note that while “risk” often carries a negative connotation, here it equally represents positive return potential (i.e., investment opportunity). In the bond market, there are many risk factors that drive performance. In particular, we find four dominant risk factors:
Duration, or interest rate risk, represents the price volatility of a long-term investment as prevailing market interest rates change.
Credit risk represents the risk of default for lending to a private corporation, consumer or risky sovereign country.
Inflation risk is driven by actual and expected changes in consumer prices.
Foreign currency risk is driven by fluctuations in exchange rates.
We believe that understanding the four risk factors – duration, credit, inflation and currency – lays the foundation for successful, strategic bond market investing. Because these factors are not highly correlated, they can provide diversification benefits in a portfolio when used together. Exhibit 2 illustrates the returns generated by these factors over the past 20 years. Since each of these risk factors is unique, they produce positive returns in different periods throughout market cycles. This can create opportunities for investors to emphasize different risks at different times and in different market environments.
Duration performance depends on how well investors are rewarded for holding longer term bonds
When establishing a basis for future return expectations, it is helpful to start with the price of risk. In bond market terminology, the term premium is the compensation an investor earns for holding longer term bonds. In this case, the term premium is essentially the price of duration risk.1 It can be measured as the difference between 10-year Treasury yields and the expected path of future short-term interest rates. In other words, when the term premium is zero, an investor should be indifferent about owning a 10-year Treasury bond versus continually reinvesting the proceeds of a three-month T-Bill for 10 years. Under normal economic circumstances, investors demand a positive term premium to compensate for the uncertainty of the future path of short-term interest rates. Based on historical data, future returns to duration are highly dependent on the beginning level of the term premium. Excess returns per unit of volatility are greatest when the term premium is high. Conversely, risk-adjusted returns have been lower when investing from a low-term-premium environment. To illustrate this, we divide historical observations of the term premium into quartiles, described as high, moderate, low and depressed (Exhibit 3). Next, we calculate prospective monthly returns based on the beginning level of the term premium. Higher beginning term premiums are associated with greater future returns, as one might expect.
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