Bonds Commentary

Duration and Diversification

May 2018

April continued what has proven to be a challenging year for bond indices and investors in the asset class. Looking out across the fixed income landscape, floating rate bonds have continued to act as a relative port in the storm, with the Bloomberg Barclays U.S. Floating Rate Notes Index returning 0.83% year-to-date through April. High-yield bonds, while generating a negative total return year-to-date, have held up far better than their investment-grade counterparts, with the Bloomberg Barclays U.S. Corporate High Yield Index declining just 0.21% versus the Bloomberg Barclays U.S. Corporate Index’s fall of 3.22%. Global unhedged bonds have held up well, in spite of a bout of U.S. dollar strength over the back half of April, with the Bloomberg Barclays Global Aggregate Bond Index generating a -0.26% total return in U.S. dollars through April, while U.S. Treasury bonds (-1.98%) and the Bloomberg Barclays U.S. Aggregate Bond Index (-2.19%) have borne the brunt of the sell-off.

Historical relationships investors rely upon to diversify portfolios in an effort to reduce volatility and limit portfolio drawdown have failed to act as desired or anticipated of late, with the poor relative and absolute performance of Treasury bonds as equities have struggled being the most noteworthy. We’ve been in an environment characterized by artificially low interest rates and minimal inflation pressures for the better part of the past decade – it’s hard to envision a better environment for bond investors. But the environment appears to be in the early innings of a meaningful and likely painful shift. Steadily increasing global demand for agricultural and energy-related commodities along with industrial metals, have forced raw input prices higher amid limited supply. The labor market in the U.S. has progressively tightened as the economic expansion has rolled along, leading to a slight acceleration in wage growth – with likely more room to run given remaining labor market slack. As quarterly results have been released, a number of companies across industries have expressed concern around rising input prices. Is this a case of management teams attempting to lower the expectations bar, or is there genuine concern surrounding margins? Regardless, data showing rising costs is consistent with other late-cycle evidence the bond market will likely focus on over the coming months and quarters, propelling rates higher.

The poor performance of investment-grade corporate bonds through April is quite telling in our view. These bonds carried historically tight spreads relative to Treasuries entering 2018, and as issuers have voiced concern over margin pressures due to rising input costs, we’ve seen bond prices fall in-kind. It’s logical that investors would reset their expectations and require a greater margin of safety, i.e. higher yields, to compensate them for any additional risk, perceived or real, but the process is no less painful. Diversification is crucial in this environment, and recent allocation shifts into dollar-denominated emerging markets debt and structured products, sourced from investment-grade corporates, should help alleviate some interest rate and credit risk in our portfolios. Along with maintaining a short duration profile relative to our benchmark, fixed income substitutes, i.e. strategies with low correlation to traditional long-only fixed income indices while still generating income, could also help lower rate risk and potential portfolio drawdown should an inflation scare materialize.

Source: Bloomberg


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