It may have been on the wind for the last few years, but it’s hardly a secret now that the three-decade-old bull market in bonds is finally winding down. Investors, many of whom were jolted from a state of complacency, have begun to take notice, pulling a record $62 billion out of bond funds in June alone. Some would say the so-called Great Rotation is underway. The crucial question, then, is “Rotation to what?” We suggest the answer to that great question is a combination of asset classes and alternative investments.
The Current Fixed Income Dilemma
Thanks in large part to the Federal Reserve's unprecedented efforts to strengthen the economic recovery by keeping rates low, investors are currently facing the threat of rates rising from what are essentially rock-bottom levels. Indeed, today’s inflation rate is already higher than the yields on many "safe" bonds. There’s no reason to expect a big spike in interest rates any time soon, but there’s every reason to look for a gradual increase over the foreseeable term. As every investor who looked at his or her second-quarter statement knows, even modest moves can trigger losses in bond portfolios.
All of this has ominous implications for asset allocation portfolios built on the proposition that bonds act as a counterbalance to stock volatility. While that basic tenet has been true enough for the last 30 years, the good results are attributable to bonds’ total return, the huge majority of which came from their rising value. In the absence of price gains, bonds will offer little if any capacity to absorb stock market shocks going forward.
Strategies Offering Potential Solutions
The good news amid all this Modern Portfolio Theory gloominess is that today’s investors and advisors—unlike their 1940 counterparts—have more than credit quality and duration at their fixed income disposal. Nothing can perfectly replace bonds in the Fixed Income category without assuming some kind of interest rate risk, of course, but there are tools that can combine to fill the gaps. We feel that list should include asset class categories like High Yield, Floating Rate Loans, Emerging Market Debt, and Dividend-Paying Equities, along with non-traditional investment strategies found in liquid alternative and unconstrained bond funds.
When properly identified and properly used, these investments can help provide bond-like returns with uncorrelated volatility. That’s not to say the task is an easy one: it will take a fair amount of work to find a blend that best serves the Fixed Income allocation for any individual portfolio. Make no mistake: There is no “magic bullet” to fix the problem. But finding the right combination could serve specific investor goals in ways that stocks and bonds alone may not.
In this, the first of a two-part series, we’ll look at specific asset class categories that can be used as tools in the search for a fixed income alternative.
Asset Class Categories
It’s well known that high yield bonds offer more coupon than government bonds or higher-grade corporates. What’s less considered is their unrelated potential for capital appreciation—high yields can benefit from a rating upgrade (usually due to improved performance at the issuing company) or an upturn in the general economy.
As a result, the sector can offer equity-like returns over the long term but with slightly less risk given the bonds’ relatively high income and their senior placement in the capital structure. From a portfolio construction perspective, high yield bonds fit into a space somewhere between equity and fixed income, though the volatility will look, and feel, more like stocks.
Floating Rate Loans
Floating Rate Loans are issued by essentially the same pool of companies as High Yield, but occupy a slightly higher spot in the capital structure (because the loans are highly collateralized they have less default risk). All things being equal, Floating Rate Loans will typically yield higher than investment grade bonds but lower than High Yield. Most important to investors, Floating Rate Loans adjust to reflect increases and decreases in market interest rates, usually through a reset every 60 to 90 days. As a result, Floating Rate investments entail virtually no interest rate risk. From a portfolio perspective, Floating Rate Loans offer a potential advantage over traditional fixed income bonds during periods of rising interest rates.
Emerging Market Debt
Emerging market bonds have evolved from a niche asset class into a high yield sector of the global bond market that offers a total return potential greater than that of U.S. Investment Grade. Given the growing number of securities and the broad range of countries that make up the EM asset class, it’s necessary to analyze risk and potential returns to identify the most attractive opportunities. Already, prices on many EM sovereign bonds have risen to reflect the improving economic prospects and higher credit quality in certain developing countries.
The benefits of emerging market bonds can include the potential for attractive yields, capital gains, currency appreciation and portfolio diversification; however, EM debt is subject to currency fluctuations and economic and political risks that may be enhanced in emerging markets.
Dividend Paying Stocks, including REITs and MLPs
Many stocks have higher dividend yields than bonds, which can be a good way to get cash flow, upside potential and lower interest rate risk. Inside a portfolio, income-focused stocks, as well as REITs and MLPs, tend to correlate with the broader equity market. From an asset allocation perspective, substituting dividend-paying stocks for bonds in a portfolio will likely generate greater income, but the portfolio will have a more aggressive and stock-heavy asset allocation with potential for volatility.
Next month, we’ll take a high-level look at determining strategies to replace current fixed-income exposure, including what to look for in an alternative mutual fund and the use of scenario testing for individual situations and objective.
Author’s disclaimer: For investment professional use only. Past performance is not indicative of future results. The opinions expressed herein reflect our judgment as of the date of writing and are subject to change at any time without notice. They are not intended to constitute legal, tax, securities or investment advice or a recommended course of action in any given situation. Investment decisions should always be made based on the investor’s specific financial needs and objectives, goals, time horizon, and risk tolerance. Information obtained from third party resources are believed to be reliable but not guaranteed. Any mention of a specific security is for illustrative purposes only and is not intended as a recommendation or advice regarding the specific security mentioned. Diversification does not guarantee a profit or guarantee protection against losses.