Why You Should (Still) Own Fixed Income by Columbia Threadneedle Investment

  • Not all bond market risks are undesirable, and understanding the key factors can help investors navigate the market cycle.
  • When used together, these factors can produce positive fixed income returns in different periods throughout market cycles.
  • The current investing landscape may appear less attractive for traditional bond portfolios, but may still offer positive total return opportunities.

Excerpted from Harnessing Fixed-Income Returns Through the Cycle by Gene Tannuzzo, CFA, Senior Portfolio Manager and Gordon Bowers III, CFA, Senior Portfolio Analyst

Understanding the risks

Should investors sell their bonds? Those who see a looming rate hike as justification for dumping their fixed income holdings should carefully weigh all the key factors (yes, there are more than one) that generate risk and return. Understanding these factors can help investors navigate the market cycle, as different fixed-income investments respond differently to the four major fixed-income risks — duration, credit, inflation and currency. Because these risk factors are not highly correlated, they can provide diversification benefits in a portfolio. When used together, these factors can produce positive returns in different periods throughout market cycles.

Exhibit 1: Risk factors produce positive returns in different stages of the market cycle
Bond market risk returns by calendar year

Fixed Income

* Credit factor returns were -34.84% in 2008 and 59.85% in 2009. These data points were truncated to fit on the chart.

Sources: Barclays, Columbia Management Investment Advisers, 12/31/14

Fixed-income asset classes respond to risk factors differently

Domestic investment-grade bond indices, such as the Barclays U.S. Aggregate Bond Index, typically derive most of their risk from duration, or interest rate, exposure, because they are mostly composed of government-backed debt with little or no credit risk. Treasury inflation- protected securities (TIPS) and investment-grade corporate bonds also derive much of their return from duration exposure.

Duration risk is more attractive when…

  • Long-term interest rates exceed expected short-term interest rates over the holding period.
  • The Federal Reserve is easing monetary policy and economic growth is slowing.
  • A flight-to-quality mindset creates demand for safe assets (typically in periods of crisis).

Duration risk is less attractive when…

  • Economic growth is improving and inflation expectations are rising.
  • Investing in a low term premium environment.

Further down the risk spectrum, below-investment-grade securities such as high-yield bonds and bank loans derive most of their price movement from credit risk; changes in corporate credit metrics and default probabilities account for most of the performance of these sectors. Duration risk is low in both asset classes.

Credit risk is more attractive when…

  • Spreads provide sufficient compensation for default risk.
  • Economic growth is stronger.

Credit risk is less attractive when…

  • Economic growth is slowing, causing financial conditions to tighten and default risk to rise.

In international markets, currency risk accounts for more than half of the performance volatility of the Barclays Global Aggregate Index.

Currency risk is more attractive when…

  • Economic growth and monetary policy abroad create attractive conditions for investing overseas.

Currency risk is less attractive when…

  • Foreign currencies tend to underperform the U.S. dollar when economic growth is waning and global interest rates are declining relative to U.S. interest rates.

Despite a broad disinflationary trend in the global economy recently, inflation risk has paid off meaningfully in specific countries at certain periods of time.

Inflation risk is more attractive when…

  • The economy is overheating.
  • Investors have very low inflation expectations, and actual inflation surprises to the upside.

Inflation risk is less attractive when…

  • The economy has a lot of spare capacity, creating little impulse for wages and prices to rise.

Investing now

Despite low yields and interest rate uncertainty, many investors still need or want bonds in their portfolios. When allocating to fixed income, we believe that the best starting point is selecting the risk factors to which an investor wants exposure. The current investing landscape may appear less attractive for traditional bond portfolios, but may still offer positive total return opportunities. A non-traditional, multi-sector fixed-income portfolio based on managing the four risk factors may:

  • Satisfy investors’ individual income goals without compromising their risk tolerance.
  • Avoid the binary outcomes that result from concentration on a single risk factor i.e. duration.
  • Lower volatility and offer potentially superior performance through all four phases of the market cycle.
  • Increase overall portfolio diversification.

Exhibit 2: Four phases of the market cycle, four fixed-income risk factors

Fixed Income