Bonds: Bigger, Broader, More Diverse Opportunity Set than Stocks
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This is part three of a five-part series on “Finding Needles in the Fixed Income Haystack.” Here are links to part one and part two.
Bond. The World is Not Enough
“Gentlemen prefer bonds.” – Attributed to Andrew Mellon (1835 – 1919)
The bond market is by far the largest securities market in the world. Depending on the methodology used, the market capitalization of the global fixed income market is one-third to three times greater than the global equity market.1 But the global and domestic bond markets are notoriously opaque.
Time to lift the fog.
The global debt market is roughly $300 trillion in size (see chart below) whereas global equity market capitalization is in the $101 to 108 trillion range. There are 60 major global stock exchanges (think NYSE and Nasdaq). According to The World Federation of Exchanges, there were 58,200 listed companies on stock exchanges across the globe.2 The Center for Research in Security Prices (CRSP) in Chicago claims there are only 3,852 listed companies on U.S. exchanges (the NYSE states there are twice that amount – 8,000 US-listed stocks).3
Let’s compare the number of U.S. listed stocks to bonds with several illustrative examples. Corporate bonds – “credit” in industry speak – are a case in point. According to CUSIP Global Services, there were 515,000 unique corporate bonds in 2021.4 There’s over a million individual agency mortgage-backed securities (MBS) pools, and nearly $300 billion in average daily trading volume.5 Add in a million munis, hundreds of thousands of individual Treasury bills, notes and bonds, plus asset-backed securities results in a pea soup fog of a $55.1 trillion (book value at yearend 2022) bond bazaar.
Only a small fraction of the millions of individual bond securities are listed on public exchanges like the NYSE, where investors can browse available securities and receive up-to-the-minute pricing information. While electronic trading dominates the equity markets, many bonds are still traded over the counter (OTC). Bond investors are also haunted, bedeviled really, by “zero-trading days.” Many bonds in bond indices, bond mutual funds and bond ETFs barely trade. By some estimates, bonds in the Bloomberg US Aggregate Bond Index (the “Agg”) trade as little as once every seven trading days.6 So, despite fawning attention mainstream media showers on the Apples, Amazons and Alphabets, the Dow Jones Average and the S&P 500, there’s little doubt that institutional and retail investors prefer bonds.
For Your Eyes Only. $300 trillion opportunity set
“I used to think that if there was reincarnation, I wanted to come back as the president or the pope or as a .400 baseball hitter. But now I would like to come back as the bond market. You can intimidate everybody.” – James Carville, Presidential adviser 1994
There’s nothing inherently wrong with core bond holdings. But given the multi-dimensional nature of the bond market, it is a mistake – and major one at that – to treat fixed income as one big homogenous asset class or category. As documented above, the global bond market has an estimated market capitalization of $305 trillion with significantly more bond issuers and bond issuances than equity counterparts.7 As for U.S. bonds, J. P. Morgan fixed income research states that the Agg captures only 49% of the U.S. bond market – a woefully incomplete picture.8
As investors seek defensive strategies to mitigate the effects of persistent inflation, macro uncertainty and market volatility, fixed income – particularly out-of-index securities – have the potential to offer attractive yield with less overall volatility than equities. Many investors are considering adding multi-sector fixed income strategies to their legacy bond portfolios to increase diversification and reduce bond benchmark-linked duration risk.
Multi-sector fixed income strategies can deliver significant benefits to investors – including yield enhancement, volatility reduction and diversification of asset-class exposures – because of managers having the freedom to make tactical shifts between fixed-income sub-sectors. Simply put, there’s more to the bond world than core.
A multi-sector fixed income strategy can provide access to opportunities in high yield (HY), while being diversified across many market segments, including IG corporate credit, floating-rate loans, and securitized products. Such an approach can provide higher income and total return potential versus core bonds, with lower volatility than dedicated high yield strategies, while diversifying the duration exposure of core bonds.
One thing we can bank on is continued bouts of volatility in rates and credit, making this epoch an ideal time to consider multi-sector strategies. If the macro picture changes, multi-sector funds have the flexibility to adjust exposures accordingly, moving across asset classes and across the credit spectrum as conditions warrant.
Shaken, not Stirred: Bond sectors are more than just the core
“There is a time for everything, and a season for every activity under the heavens.” – Eccles. 3:1-9
Morningstar maps a total of 14 fixed income sectors which roll up into five bond “super sectors.”9 The “Callan Periodic Table of Investment Returns – U.S. Fixed Income” (above) has eight bond “super” sectors and two dozen sub-categories.10 Asset managers dissect the fixed income markets with varied categories. JP Morgan has ten (10) fixed income categories, Fidelity International and Eaton Vance each have eight bond sectors, Vanguard segments the bond market into 10 sectors and Franklin Templeton tracks 18 fixed income sectors.
The top two components of the Bloomberg U.S. Agg have an 81% correlation to one another. Given the size of the debt markets, there is ample diversification potential in other bond sectors. Some of the best investments have been in opportunistic sectors that are not eligible for inclusion in the Agg, for example, non-agency MBS, emerging market local debt, high-yield, and global debt. An active approach can invest in the broad fixed income universe. The ability to access sectors outside the benchmark can provide active managers with a distinct advantage over the Agg.
The ability to move tactically between sub-sectors provides attractive opportunities: No single fixed income asset class has outperformed consistently over time and opportunities arising from short-term market selloffs can evaporate rapidly. As illustrated in the Fixed Income Sector Periodic Table 2007-2022, the volatility of returns for key fixed income asset classes varies substantially by time frame and some sectors will exhibit non-traditional risk-return profiles, creating short-term opportunities which could (ideally) be exploited by a nimble manager.
A Quantum of Solace: Multi-sector fixed income
“Bond investors are the vampires of the investment world. They love decay, recession – anything that leads to low inflation and the protection of the real value of their loans.” – Bill Gross, “Bond King”
Multi-sector fixed income portfolios offer a quantum of solace – a measure of comfort – compared to equities or funds tied to the Agg. If a bond manager hugs the Agg index, high yield, floating rate and inflation-linked bonds (TIPS, ILBs or known colloquially as “linkers”) are off the table because none of these sectors are included in the Agg.
For the first two decades of the 21st century, the stock–bond correlation was consistently negative, and investors were largely able to rely on their bond investments for protection when equities sold off.11 Bonds were great diversifiers over this 20-year period. Between 2000 and 2021, the stock-bond correlation averaged -0.3. But in 2021, equity and bond correlations started to creep upward (using the S&P 500 vs. 10-year Treasury). In July 2023, the one-month correlation between the Bloomberg US Treasury Total Return Index and the S&P 500 soared to 0.82.12 There is cure for creeping correlations for advisors and investors who consider allocating to bond sectors unrelated to U.S. government securities.
Many fixed income sectors are non-correlated to one another to provide a diversification benefit. (See chart above for five bond sectors correlation to U.S. stocks.) Many multi-sector bond portfolios have compelling risk-to-reward ratios (Sharpe ratios) and lower standard deviation than equity-linked portfolios.
For bond investors willing to move outward on the efficient frontier, there are less correlated bond issues that historically have offered higher returns. Non-investment grade corporates, investment-grade emerging market local debt (Argentina need not apply), preferreds, and floating rate bonds offer appreciably higher yields than Treasurys or AA credit bonds. Floating rate bonds were one of the safe havens in 2022 – eking out a small return in a record bad bond beta climate.
A multi-sector fixed income manager can trade bond market sectors often overlooked by larger peers and may avoid issuers with higher idiosyncratic risks. A multi-sector bond strategy should be constructed with opportunistic yield in mind rather than the constraints of a 50-year-old bond benchmark. Several ways to diversify a core bond allocation is to add exposure to higher-rated, high yield credits or emerging market local debt (for the dollar bears). These securities offer a spread over government securities. The added credit spread is compensation for the risk of moving away from U.S.-backed securities, including the risk of default. Over longer holding periods, the additional credit spread typically compensates investors for a default risk, resulting in a higher terminal value than core bond holdings.
The fixed income investment universe is more complex and segmented, leading to inefficiencies, mispricing, and structural market effects. Active multi-sector bond fund managers have a broader “opportunity set” by considering a wide spectrum of fixed income securities. In contrast, passive fixed income strategies are straight jacketed by rule seeking only to match the risk and return of a benchmark by attempting to mirror the sector allocation, issuers, duration, credit quality, and yield-curve exposure. Today’s market regimes mandate a tactical approach to fixed income trading, with the ability to move between fixed income segments based on economic indicators and market opportunities.
There’s an added potential benefit of allocating to multi-sector bond funds. In the 27-year period from 1994-2020, the fixed income sector that delivered the highest annualized excess return among active bond funds was multi-sector. The median (half above/half below) excess return of multi-sector bond funds was 88 basis points per year. The 95th percentile (aka the top 5%) of multi-sector fixed income funds generated 2.36% (236 bps) of excess return per annum over the multi-sector fund benchmark, the Bloomberg U.S. Universal Total Return Unhedged USD Index.13
Allocation to subsectors like non-investment grade, emerging market debt, and floating rate securities can offer improved yields and diversification benefits. In some cases, these fixed income categories may be sectors that an investor would struggle to allocate to on a standalone basis due to minimum investment size thresholds. A proven way to access these fixed income sectors is through multi-sector bond ETFs or mutual funds.
Skyfall? No, live another day
“The fog comes on little cat feet.
It sits looking over harbor and city
on silent haunches and then moves on.” – Fog by Carl Sandburg (1916)
The journey to select experienced and benchmark beating tactical bond strategists begins by identifying multi-sector bond specialists because there’s much more than just core bonds. The U.S. and global bond markets are vast – much bigger than U.S. or international equity market capitalizations. A multi-sector managed bond ETF or mutual fund means that, no matter which way markets, interest rates and credit spreads move, opportunities can be sourced here at home and around the world.
Because multi-sector fixed income portfolio managers aren’t tied to the Agg, they have the flexibility to target non-benchmark interest rate and credit risk exposures. This key fact may explain in part how many multi-sector portfolios have lower duration, fewer downgrades, and less default risk than benchmark-hugging bond indexers.
Multi-sector strategists overweight or underweight bond sectors on fundamental, quantitative, and technical research. This undertaking allows them to make informed assessments about security selection and specific sector forecasts. Their role as active investors is to consider growth prospects, current inflation prints and monetary policy across economies and to determine if these factors are fully reflected in the pricing of rates, credit spread and default risk.
It's vital to identify proven multi-sector fixed income strategists whose actual transaction costs of sector rotation and reallocations are below the excess returns generated so that after cost-alphas remain substantial. Remember the rationale for underweighting or overweighting bond sectors and incorporating risk premia factors is to beat passive bond indexers on a risk-adjusted basis.
Rick Roche, CAIA, is managing director of Little Harbor Advisors, LLC, a position he has held since April 2013. He is a 42-year veteran of the industry, dually registered adviser, and CAIA charter holder. Over the course of four decades, he’s trained thousands of credentialed financial advisors in practice management and a variety of timely investment topics (85+ CE programs over the last 4-5 years). His bio is here.
The information contained in this publication was obtained from sources believed to be reliable, but its accuracy cannot be guaranteed. Opinions expressed herein are those of the author, Rick Roche, and not those of Little Harbor Advisors (LHA).
1 Certain organizations tally global and US fixed income market capitalization based on par (book) value of the debt issued whereas other data collectors use the market value of debt issued. Global debt expressed in USD equivalent.
2 The WFE Research Team, “Number of Listed Companies”. The World Federation of Exchanges, May 2022.
3 CRSP, LLC, “CRSP Market Indexes, US Market Update”, April 2023.
4 Wigglesworth, R. and Fletcher, L. “The next quant revolution: shaking up the corporate bond market”, FT, Dec 7, 2021.
5 Fuster, A. et al., “Mortgage-Backed Securities”, Federal Reserve Bank of New York Staff Reports, no. 1001, February 2022.
6 Cremers, Martijn, Choi, J., & Riley, T., “Why Have Actively Managed Bond Funds Remained Popular?”, June 2023.
7 Wilkes, T., Reuters, “Emerging markets drive global debt to record $303 trillion – IIF”, Feb 23, 2022; and Institute of International Finance, Global Debt Monitor May 17, 2023.
8 J. P. Morgan, “Build Stronger Fixed Income Portfolios”, Winter/Spring 2023.
9 Morningstar Office, Bond Sectors, 2023.
10 Callan Institute, “Market Pulse, Third Quarter 2022”, page 58.
11 Brixton, A., AQR, “A Changing Stock-Bond Correlation: Drivers and Implications Q1 2023”, The Journal of Portfolio Management, March 2023.
12 Xie, Ye, “Bonds Are Useless Hedge for Stock Losses as Correlation Jumps”, Bloomberg, Aug 2, 2023.
13 Ibid., Tidmore, C., Hon, A., “Vanguard Research, July 2021.
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