Global Fixed Income
Weekly discussion of fixed income market action and what it may mean for investors.
Brian Rehling, CFA, Co-Head of Global Fixed Income Strategy
The Case for Intermediate Fixed Income
- We expect a lower-for-longer rate environment, which can make the yield pickup available in intermediate-term fixed income attractive to investors.
- This asset class may be an appropriate area to consider for investment of cash-alternative balances given currently low money-market yields.
What it may mean for investors
- We are currently overweight on intermediate-term fixed income in view of its yield and diversification benefits for portfolios today.
Treasury yields remain low, and we do not expect a sustained and material yield increase in the intermediate-to-long end of the yield curve. We expect that Federal Reserve (Fed) rates hikes will occur at a very slow pace and that a “lower for longer” rate environment remains intact. This confluence of factors helps to explain our overweight on intermediate-term fixed income today. We believe that this asset class should continue to provide investors with modest returns coupled with limited downside volatility in the tactical time frame.
Ever since the financial crisis, many investors have remained more concerned about losing money than (potentially) making money on their investments. This is evident from the large cash-alternative investment (“cash”) balances that many investors currently hold as they seek to avoid market risk and volatility. In our opinion, intermediate fixed income is a better alternative to “cash” investments (such as money market funds) today. The current yield on the Bloomberg Barclays U.S. Aggregate 5-7 Year (bond) Index is 2.18 percent, a yield that is attractive relative to cash-alternative yields. While there is risk associated with intermediate fixed income, we view the risks as manageable and believe that this debt class offers investors an attractive option among lower-volatility asset classes.
Chart 1 looks at rolling 12-month returns for the Bloomberg Barclays U.S. Aggregate 5-7 Year Index from 2003 to today. This is a period that includes a Fed rate-hike cycle in which the Fed increased rates by 4.25 percent. The time period also covers the 2013 taper tantrum in which the 10-year Treasury yield increased by almost 1.50 percent in just a few weeks. Over the past 13 years, this intermediate-term index posted a negative 12-month total return just 7.2 percent of the time. The largest 12-month total-return loss for the index was 3.3 percent in 2004. Chart 1 illustrates that significant and/or sustained losses in this intermediate investment-grade fixed income index have been a historically rare event. We expect a similar pattern to play out for this asset class in the future. Of course, past performance is no guarantee of future results. In our opinion, the opportunity for 2-3 percent total-return potential with a limited volatility profile makes the asset class attractive.
In addition to a relatively attractive risk/return profile for the intermediate fixed income asset class, we believe that investors also should consider the additional benefits that high-quality fixed income can add to a well-diversified portfolio.
Correlation: High-quality fixed income often sees its best performance during periods of market stress. This “correlation diversification” can be reason enough to include fixed income in your asset allocation.1 In simple terms, bonds may help boost your overall returns when equities are under selling pressure; an investor also must accept that the opposite can also be true (bond returns can be relatively less stellar, or even negative, when equities, or interest rates, are rising). Over the longer term, bonds (when used properly as part of a diversified investment strategy) may help smooth out your portfolio’s overall performance.
Liquidity: Regardless of interest-rate movements, if you are able and willing to hold a fixed-income security until its maturity date, your cash flow is expected to be relatively predictable, absent early redemption or a credit event such as an issuer default. While the price of your investment will fluctuate based on interest-rate and market movements, your expected cash flow and proceeds at maturity typically remain unchanged (unless you sell the holding or the issuer defaults or calls the bond). If you are able to anticipate future cash-flow needs, purchasing high-quality credit instruments with maturities near those occasions can be an effective way to remain invested in the markets while maintaining some assurance that funds will likely be available when you need them.
An additional factor to consider is that—as bonds “roll down” the interest-rate curve—they move closer to maturity and become less interest-rate sensitive. If interest rates were to unexpectedly rise significantly, the roll-down effect, coupled with a bond’s approaching maturity, could limit the price decline an investor might experience in the intermediate-term fixed income class.
The Big Picture
As noted, our expectation for Fed rate increases that are likely to be slower for longer supports our overweight recommendation in intermediate fixed income given the available yield pickup.
We recommend that investors build well diversified, fixed-income allocations—diversified across sectors, maturities and geography. Duration positioning also is critical for fixed-income investors. Duration measures a bond’s price sensitivity to interest-rate changes. Bonds with shorter durations tend to be less sensitive to changes in interest rates. We currently recommend that investors position just short of duration benchmarks—as a result of the low-rate environment and our hesitancy to lock in current rates for a significant period of time. Conversely, investors must take care not to move too short and be left with little yield/income generation potential in their portfolios.
1 Correlation measures how two investments move in relation to each other. The correlation coefficient ranges between -1 and +1. A value of 1 signifies perfect positive correlation (as one investment moves up or down, the other investment will move in alignment, in the same direction). A value of -1 implies negative correlation (the assets move in exactly opposite directions).
All investing involves risk including the possible loss of principal.
Diversification cannot eliminate the risk of fluctuating prices and uncertain returns.
Investments in fixed-income securities are subject to interest rate and credit risks. Bond prices fluctuate inversely to changes in interest rates. Therefore, a general rise in interest rates can result in the decline in the bond’s price. Credit risk is the risk that an issuer will default on payments of interest and principal. High yield fixed income securities are considered speculative, involve greater risk of default, and tend to be more volatile than investment grade fixed income securities. If sold prior to maturity, fixed income securities are subject to market risk. All fixed income investments may be worth less than their original cost upon redemption or maturity.
An index is not managed and not available for investment.
Bloomberg Barclays U.S. Aggregate 5-7 Year Bond Index is unmanaged and is composed of the Barclays U.S. Government/Credit Index and the Barclays U.S. Mortgage-Backed Securities Index, and includes Treasury issues, agency issues, corporate bond issues, and mortgage-backed securities with maturities of 5-7 years.
Global Investment Strategy (GIS) is a division of Wells Fargo Investment Institute, Inc. (WFII) WFII is a registered investment adviser and wholly-owned subsidiary of Wells Fargo & Company and provides investment advice to Wells Fargo Bank, N.A., Wells Fargo Advisors and other Wells Fargo affiliates. Wells Fargo Bank, N.A. is a bank affiliate of Wells Fargo & Company.
The information in this report was prepared by Global Investment Strategy. Opinions represent GIS’ opinion as of the date of this report and are for general information purposes only and are not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally. GIS does not undertake to advise you of any change in its opinions or the information contained in this report. Wells Fargo & Company affiliates may issue reports or have opinions that are inconsistent with, and reach different conclusions from, this report.
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