Error message

Warning: implode(): Invalid arguments passed in envestnetpmc_mod_views_pre_view() (line 65 of /mnt/www/html/envestnetpmc/docroot/sites/all/modules/custom/envestnetpmc_mod/envestnetpmc_mod.module).

Commentaries

PMC Weekly Review – November 30, 2018

Re-Thinking the “Core” In a Core Bond Allocation

One of the fastest-growing areas of the wealth management business today is the multiasset model portfolio. Each model is actually a series (usually five to seven) of risk-based portfolios, suiting the needs of most investors. These managed account strategies are available from a wide range of providers with different goals and objectives, but they generally tend to be long-term, diversified, strategic asset allocations, using passive or active investment vehicles (or both) to achieve their allocation targets. Some model providers stick to very high-level asset classes; some broaden their opportunity set to include very specific asset classes, such as small cap non-US equities or local currency emerging markets debt. But present in nearly all of these models is exposure to the domestic, investment grade fixed income market, with significant allocations in the most conservative portfolios. This allocation is designed to provide income, preserve capital, and offset the volatility of the global equity markets. Typically, this exposure is achieved via a mutual fund or ETF that tracks maturities from 1-15 years like the Bloomberg Barclays Intermediate Government/Credit Index or the full spectrum of maturities like the Aggregate Index.

However, investors today are faced with a bit of a problem when it comes to this core fixed income allocation. Namely, it is unlikely to generate anything like the levels of income or total return over the next decade as it did over the last ten years, let alone the last 30. August 2016 likely marked the end of a 35-year bull market in US interest rates (as far as we know), and we now potentially face an extended period of flat (in a best case) to rising rates. In response to the financial crisis, the Federal Reserve (Fed) cut short-term rates to zero to stimulate the economy, and since then investors have struggled to generate the appropriate level of income in their core allocations. They have been forced to either extend the maturity of their portfolios (adding interest rate risk) or invest more in lower-rated, riskier credits (adding default risk), or both, to achieve their income or return goals.

At the end of 2007, the Aggregate Index had an average annual return of nearly 6.0% over the preceding decade and an average coupon of more than 5%. Falling rates and spread tightening (due to the high demand for corporate and securitized debt) boosted returns from 2008 to 2017. But companies and homeowners moved to refinance older, higher-coupon debt at much lower interest rates, limiting investor gains from falling rates and lowering the income component every year. By the end of 2017, the ten-year average annual return for the Aggregate Index had dropped to slightly more than 4.0%, and the average coupon had fallen roughly 200 basis points, to just above 3%. In short, the average return for the index (and really any intermediate-term bond index) over the coming decade is likely to be lower than the 2008-2017 period, and the income component, although likely to rise over the next ten years, will not match that of the previous ten-year period.

It is certainly possible domestic or global macroeconomic issues could force interest rates lower across the yield curve, but the potential gains from reverting even to the post-financial crisis lows are relatively limited. Spreads on corporate and securitized bonds will have a bias to widen over the next ten years, as corporate spreads are at or near all-time lows. Securitized spreads have already started to revert to their long-term averages, driven in part by the Fed no longer reinvesting principal and interest into new MBS securities for its balance sheet. Thus, investors should strongly consider the possibility that total returns in the first half of the next decade will be lower than the current coupon, as modestly rising rates and widening spreads create capital losses. The second half of the next decade is less clear (as always), but total returns should be close to then-prevailing income levels (i.e., modestly higher than today).

As a replacement option, investors could consider focusing on the ends of the yield curve rather than the middle. Placing 60%-80% of the core bond allocation in a short-term portfolio and the remainder in a long-term portfolio could very well provide more income and better total returns. The short-term portfolio, focused on the first three years of the yield curve, will be less affected by rising interest rates and more able to quickly add higher-coupon bonds, as 20%-40% of the portfolio will mature every year. A long-term portfolio, invested primarily in Treasurys focusing on the last ten years of the yield curve, can provide additional income. This portfolio will be very sensitive to interest rates, but rates in this portion of the curve are driven almost entirely by inflation expectations rather than by Fed policy or short-term macroeconomic events. Although this solution might not be appropriate for every investor in every situation, it is definitely worth taking the time to examine the assumptions built into any core bond allocation.'

Nathan W. Behan, CFA, CAIA |
Senior Vice President, Investment Research

 

Download the full PDF

The information, analysis, and opinions expressed herein are for general and educational purposes only. Nothing contained in this weekly review is intended to constitute legal, tax, accounting, securities, or investment advice, nor an opinion regarding the appropriateness of any investment, nor a solicitation of any type. All investments carry a certain risk, and there is no assurance that an investment will provide positive performance over any period of time. An investor may experience loss of principal. Investment decisions should always be made based on the investor’s specific financial needs and objectives, goals, time horizon, and risk tolerance. The asset classes and/or investment strategies described may not be suitable for all investors and investors should consult with an investment advisor to determine the appropriate investment strategy. Past performance is not indicative of future results.

Information obtained from third party sources are believed to be reliable but not guaranteed. Envestnet|PMC™ makes no representation regarding the accuracy or completeness of information provided herein. All opinions and views constitute our judgments as of the date of writing and are subject to change at any time without notice.

Investments in smaller companies carry greater risk than is customarily associated with larger companies for various reasons such as volatility of earnings and prospects, higher failure rates, and limited markets, product lines or financial resources. Investing overseas involves special risks, including the volatility of currency exchange rates and, in some cases, limited geographic focus, political and economic instability, and relatively illiquid markets. Income (bond) securities are subject to interest rate risk, which is the risk that debt securities in a portfolio will decline in value because of increases in market interest rates. Exchange Traded Funds (ETFs) are subject to risks similar to those of stocks, such as market risk. Investing in ETFs may bear indirect fees and expenses charged by ETFs in addition to its direct fees and expenses, as well as indirectly bearing the principal risks of those ETFs. ETFs may trade at a discount to their net asset value and are subject to the market fluctuations of their underlying investments. Investing in commodities can be volatile and can suffer from periods of prolonged decline in value and may not be suitable for all investors. Index Performance is presented for illustrative purposes only and does not represent the performance of any specific investment product or portfolio. An investment cannot be made directly into an index.

Alternative Investments may have complex terms and features that are not easily understood and are not suitable for all investors. You should conduct your own due diligence to ensure you understand the features of the product before investing. Alternative investment strategies may employ a variety of hedging techniques and non-traditional instruments such as inverse and leveraged products. Certain hedging techniques include matched combinations that neutralize or offset individual risks such as merger arbitrage, long/short equity, convertible bond arbitrage and fixed-income arbitrage. Leveraged products are those that employ financial derivatives and debt to try to achieve a multiple (for example two or three times) of the return or inverse return of a stated index or benchmark over the course of a single day. Inverse products utilize short selling, derivatives trading, and other leveraged investment techniques, such as futures trading to achieve their objectives, mainly to track the inverse of their benchmarks. As with all investments, there is no assurance that any investment strategies will achieve their objectives or protect against losses.

Neither Envestnet, Envestnet|PMC™ nor its representatives render tax, accounting or legal advice. Any tax statements contained herein are not intended or written to be used, and cannot be used, for the purpose of avoiding U.S. federal, state, or local tax penalties. Taxpayers should always seek advice based on their own particular circumstances from an independent tax advisor.

© 2018 Envestnet. All rights reserved.