Outside our 12th floor window just east of Bryant Park in New York City, this weekend is filled with a familiar sound of the approaching change of seasons—the birds of spring have arrived. As surely as the seasons themselves vary each year in duration and temperature extremes, so too is the inevitability of their eventual turning. Similarly, economic and credit cycles each vary in length and extremes, often owing to the natural forces of fear and greed that govern our individual and collective lives. Sometimes, these cycles are unnaturally shortened or extended by well-intentioned intervention by our governing officials. And sometimes, as appears to be the case now, cycles are abruptly curtailed by a black swan—an unforeseen event of extreme impact. COVID-19 (coronavirus disease 2019) could be just such a catalyst for the turn in our current extended economic and credit cycle. Investors around the world are voting with their cash, aggressively selling stocks and buying high-quality U.S. bonds.
The song lyrics in the lead-in above are timeless, and much older than The Byrds 1962 retelling. They’re nearly as old as written history itself, originating from one of the Poetry and Wisdom books of the Hebrew Bible (Ecclesiastes 3:1-8). Timeless wisdom has a self-evidentiary nature to it. Investing, too, has its equivalents; perhaps none more so than the principle of diversification. After a more than a 10-year expansion and bull run in stocks, it’s understandable that investors would have questioned their allocation to bonds, particularly given the historically low yields on offer. But as this recent sharp correction in stocks reminds us, income generation is but one characteristic feature—not the raison d’etre—for bonds in an asset allocation framework. Rather, it’s the diversification benefit that bonds provide. More than any other primary asset class, high quality bonds zig when stocks zag. In more technical terms, equities and bonds are negatively correlated. And while, of course, during stock market advances you’ll be sacrificing some return by owing bonds, you do so in exchange for the downside protection they provide during equity market declines such as we are currently experiencing. This is portfolio construction 101.
Quality matters. To be clear, not all bonds are negatively correlated with stocks and thereby do not provide this important downside protection. In periods of economic and market turmoil, investors are quickly reminded that their high-yield bonds have an alias—they are also known as junk bonds. Not surprisingly, these bonds, which provide the highest income, also carry the most risk. When investors become risk-averse, high-yield bonds underperform just like stocks, providing little diversification benefit. In contrast, government and high-quality corporate and municipal bonds are more likely to provide the intended behavior of bonds in a prudent asset allocation framework.
Technology matters. Before the advent of mutual funds, investors humbly accepted that to predict the direction of interest rates was folly; it’s better to have a diversified portfolio of high-quality bonds maturing regularly, thereby always capturing the prevailing average market yield. In mutual funds, investors were sold a different story in different packaging—professional management in a pooled fund alongside other investors at higher fees. Index funds, and later, ETFs mitigated many of the issues associated with individual investors getting their bond market exposure through mutual funds. The parallel development of electronification of the bond market, alongside fully integrated mass customization portfolio technology is creating an entirely new post-fund world. Investors can now create and execute custom portfolios of high quality, liquid bonds with a few clicks of their mouse or taps on their tablet. User interfaces have evolved to enable more intuitive and tailored portfolio risk management for portfolio managers, while simplifying and elevating the fixed income discussion for advisors, resulting in increased client engagement.
If you’re like most portfolio managers and advisors, you probably have succumbed to the allure of high-yield and forgotten the important role that high-quality bonds play in an asset allocation framework. Moreover, you may not have kept pace with the rapidly evolving technological landscape in fixed income. Given the change of seasons underway, in both markets and market structure, it behooves one to revisit each of these fundamental elements—asset quality and technology—and decide if it’s a time for change…I swear it’s not too late.
Dan Taylor is head of client solutions at BondIT, an independent portfolio construction technology provider for fixed income. Email him at [email protected]
