by Rick Friedman, GMO LLC
Low interest rates are hardly new. Global sovereign debt yields continue to grind lower and squeeze savers looking for income (Chart 1 displays this persistent decline). Accommodative central banks and willing (and in some cases, unwilling) investors have pushed the majority of developed sovereign debt yields below 1%, and about one-third of sovereign debt securities are trading at negative yields! In fairness, slowing economies, demographic shifts, and sluggish inflation argue some decline in rates may have been warranted.
Hungry like the wolf: The reach for yield
Not surprisingly, income-hungry investors are starving and have been reaching for yield. Cash investors have had to pick up some interest-rate risk pushing bond-holders from traditional bonds that are viewed as safe to high-yield debt securities or other “bond substitutes.” Yield-seekers moved out on the risk spectrum, turning to asset classes like Real Estate Investment Trusts (REITs), Master Limited Partnerships, dividend stocks, and emerging-markets debt in hopes of generating the returns they used to get from high-quality bonds. Central banks have continued—and in some cases, added to—accommodative policies, leading income-hungry investors farther from their natural habitat. Most recently, emerging markets debt funds experienced strong inflows given their attractive relative yields. And many “bond substitutes” have performed well this year, outperforming the broad stock market (Chart 2 shows their strong results).
Historical role of bonds in a portfolio
Bonds play two principal roles in a portfolio. Steady coupons typically generate fixed income, and the contractual repayment of principal payment helps mitigate risk across a diversified portfolio. Amid deflationary periods and recessions, investors have typically fled to the perceived safety of high-quality bonds, which may provide an important offset to declines in risky assets. In inflationary and stagflation environments, however, there’s no predicting what can happen, and bonds may add to the pain.
So how are bonds doing today? Traditional bonds are failing to provide an attractive income stream, but at least they may safeguard portfolios against a large drawdown in equities (unless inflation is aggressively rearing its head). What about bond substitutes that offer better yield today? Will they offer downside mitigation? Doubtful, as investors move further into riskier substitutes, the assurance of principal payment typically declines. In periods of stress, fundamentals tend to erode, defaults often rise, investors typically flee, and prices generally fall.
Two historical periods come to mind: The Russian Debt Crisis of 1998 and the more recent Global Financial Crisis demonstrate this pattern. High-quality U.S. Treasuries offered an important safe haven in both periods, but bond substitutes added to the pain (see Chart 3). These bond substitutes may have helped provide income, but they failed miserably to protect principal when investors needed it most.
What investors may want to keep in mind
Today, we believe traditional bonds offer a poor risk/return trade-off because of their low yield and long duration, and would likely incur losses, if interest rates rise. With good credit analysis and realistic assumptions, selectively adding some higher-yielding exposures to a portfolio may make sense. However, even if “bond substitutes” present a compelling investment case, investors may want to think twice before automatically viewing them to be the “safe” part of a portfolio.
More important, investors may want to weigh the potential benefits of holding some cash in an effort to both safeguard against drawdowns and act as “dry powder.” While cash at today’s paltry yield levels may offer modestly negative returns after inflation, it likely will not decline in a sudden market sell-off or spike in rates—and may offer flexibility to patient investors looking to deploy capital, when they’re getting paid to do so.
There are certainly scenarios in which traditional bonds such as sovereign debt or inflation-linked bonds (Treasury Inflation-Protected Securities or TIPS) could be helpful, like a growth shock, recession-linked equity market sell-off, or a continued period of low rates. When considering “bond substitutes,” investors may want to remember their history of acting anything but bond-like.
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The views expressed are as of 10-10-16 and are those of Rick Friedman, GMO LLC, and Wells Fargo Funds Management, LLC. The information and statistics in this report have been obtained from sources we believe to be reliable but are not guaranteed by us to be accurate or complete. Any and all earnings, projections, and estimates assume certain conditions and industry developments, which are subject to change. The opinions stated are those of the authors and are not intended to be used as investment advice. The views and any forward-looking statements are subject to change at any time in response to changing circumstances in the market and are not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally, or any mutual fund. Wells Fargo Funds Management, LLC, disclaims any obligation to publicly update or revise any views expressed or forward-looking statements.
Wells Fargo Asset Management (WFAM) is a trade name used by the asset management businesses of Wells Fargo & Company. Wells Fargo Funds Management, LLC, a wholly owned subsidiary of Wells Fargo & Company, provides investment advisory and administrative services for Wells Fargo Funds. Other affiliates of Wells Fargo & Company provide subadvisory and other services for the funds. The funds are distributed by Wells Fargo Funds Distributor, LLC, Member FINRA, an affiliate of Wells Fargo & Company. Neither Wells Fargo Funds Management nor Wells Fargo Funds Distributor has fund customer accounts/assets, and neither provides investment advice/recommendations or acts as an investment advice fiduciary to any investor.
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