As the research team and I sat down to discuss the results of our year-end client survey, we saw two big questions emerge from the data: 1. Are bonds going to be able to provide the necessary hedge for portfolios, and 2. Is value finally starting to make a comeback after a rough 10 years? 2019 may prove to be a more challenging landscape than 2018, so investors are will need to do some hefty due diligence. To start, I want to dig into the first question around bonds.

Today, the heritage traditional core bond exposure, the Bloomberg Barclays US Aggregate Bond Index (the Agg) is on the verge of doing something it has done just three times in the last 40 years—post a negative total return. Yet, in each of those three periods when bonds were negative, stocks were positive, offering some hope for a positive return in the standard 60% equity / 40% bonds allocation.1 This year, the Agg’s negative total return occurs with 72% of MSCI ACWI stocks trading below their 200-day moving average while also well off their 52-week highs.2 In fact, the median difference to an ACWI stocks’ current price and their respective 52-week highs is negative 22%.3 And 57% of global stocks are trading down at least 20% from their 52-week high, and therefore are in bear market territory!4

This raft of negativity threatens the total return of a standard 60/40 allocation. Currently, the standard 60/40 allocation, shown below, is headed for its worst return since the financial crisis. At that time stocks were down 42%, but bonds were up, providing the necessary ballast to portfolios. If today’s returns hold, 2018 would be the first time in the last 27 years that both bonds and stocks fell in the same year, leading to a return nearly 13% below the long-term median calendar year return of the standard 60/40 portfolio. Looking at this portfolio on a price return basis paints an even bleaker picture, as rising rates have resulted in the Agg producing a negative rolling 3-year price return for the last 24 consecutive months.5

Bond sector selection: A key to mitigating equity risk

Even with the challenges of our low return, low yield environment, bonds remain a critical diversifier. Importantly, however, rising rates may have altered the relative attractiveness of various bond sectors to hedge equity risk. First, the traditional Agg is no longer the ideal tool based upon its asymmetric yield and duration profile, as shown below. As yields fell but duration became extended due to ultra-accommodative monetary policies, the cushion afforded by the coupon on these bonds no longer outweighed the effects of duration-induced price declines, leading to sharper, more severe drawdowns that have accelerated during this rising rate period. 

please insert chart here

Source: Bloomberg Finance L.P., as of 11/19/2018. 

Further, as the Federal Reserve (Fed) has hiked rates, the yields of shorter duration vehicles have risen along with the Agg, creating more opportunities to generate income without taking on sizeable duration risks. We’ve seen strong absolute and risk-adjusted performance since the start of 2017 when the Fed started to raise rates in earnest, as the seven hikes have created a differentiated return stream and risk profile for shorter duration bonds compared to the Agg. The chart below compares the rise in yields on US 3-month T-Bills, floating rate notes, and 1-3 year corporate bonds to the Agg as the Fed pushed rates higher. 

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Source: Bloomberg Finance L.P., as of 11/19/2018.

From a portfolio construction perspective, whether it’s generating income or managing risk, exposures on the short end have become more attractive, especially when considering that none of the instruments shown above have a duration level higher than 2 years. The Agg has a duration north of 6 years. Investment grade floating rates notes, however, carry a duration figure of less than 3 months, which when coupled with the 129% increase in yield on floating rate notes since 2017, result in floaters posting a Sharpe ratio of 5.25 over this time period.6 They say to beware of the 3 Sharpe ratio strategies, but say nothing about the 5! While this is much greater than the historical Sharpe for floating rates, the last two years have been a period of rising rates which would benefit a low duration investment grade floating rate strategy, as evidenced by floating rate notes posting positive returns on 96% of the days over this time period, compared to 54% for the Agg.7

To mitigate equity risk, consider focusing on bond sectors’ correlation to equities, yield per unit of duration, and drawdown performance since the Fed began to raise rates, considering the indication for one more hike in 2018 and three in 2019. Credit spread is also important to consider to guard against adding just low-beta equity risk through credit instruments. As shown below, investment grade ultra-short and short-duration bonds may be a better risk mitigation tool versus equities while providing some income, given their limited drawdowns, attractive yield per unit of duration, low credit risk and low correlation to equities.

please insert chart here

Source: Bloomberg Finance L.P., as of 11/19/2018.
T-Bills: Bloomberg Barclays U.S. Tr Bills 1-3 Months Index; Floating Rate Notes: Bloomberg Barclays US FRN < 5 yrs Index; Senior Loans: S&P/LSTA U.S. Leveraged Loan 100 Index; Short Term Corp: Bloomberg Barclays US Corporate 1-3 Year Index; Short Term Treasuries: Bloomberg Barclays U.S. Treasury 1-3 Year Index; US HY: Bloomberg Barclays US Corporate High Yield Index; Agg: Bloomberg Barclays US Agg Index; EM Debt: Bloomberg Barclays EM USD Aggregate Index; Investment Grade Corp: Bloomberg Barclays US Corporate Index.

Because senior loans have a strong yield and duration profile but increase an exposure’s equity correlation given the credit risk, they may not provide ballast in the core as it would be trading bond risk for equity-lite risk. However, given their performance in 2018, senior loans could potentially enhance returns.

Looking ahead: Bonds remain an important hedge

Hindsight is 20/20, but an equal weighted allocation to investment grade floating rate notes, Treasury bills, and 1-3 year corporates alongside a position in the Agg would have improved a 60/40 portfolio’s return by 30% through October.8 The total portfolio return would have still been negative given the downside move in equities, but the bond sleeve’s positive return would have buffered the stock market’s drawdowns to avoid the acrimonious distinction of having both sleeves in a 60/40 portfolio down at the same time for the first time since 1990.

The environment that led to these returns is likely to persist. Therefore, investors looking to balance equity risk as we head into a year that likely will be marked by ongoing geopolitical tensions, concerns over global growth and an extended bull market in US equities, should consider shortening up on duration, focusing on higher grade segments and rotating into floating structures like floating rate notes.

Stay tuned to SPDR Blog, as my next post in the 2019 Market Outlook series tackles the second big question on investors’ minds: after a lost decade, will value start making a comeback?

1Bloomberg Finance L.P., as of 11/19/2018.
2Bloomberg Finance L.P., as of 11/19/2018.
3Bloomberg Finance L.P., as of 11/19/2018.
4Bloomberg Finance L.P., as of 11/19/2018.
5Bloomberg Finance L.P., as of 11/19/2018.
6FactSet, as of 10/31/2018.
7Bloomberg Finance L.P., as of 11/19/2018.
8FactSet, as of 10/31/2018.

Definitions

Bloomberg Barclays US Aggregate Bond Index (the Agg)
A market-weighted index, meaning the securities in the index are weighted according to the market size of each bond type. Most US traded investment grade bonds are represented. Municipal bonds and Treasury Inflation-Protected Securities are excluded, due to tax treatment issues. The index includes Treasury, Government agency bonds, Mortgage-backed bonds, Corporate bonds and a small amount of foreign bonds traded in the US.

Bloomberg Barclays US Corporate Bond Index
A fixed-income benchmark that measures the investment-grade, fixed-rate, taxable corporate bond market. It includes USD denominated securities publicly issued by US and non-US industrial, utility and financial issuers.

Duration
A commonly used measure, expressed in years, that measures the sensitivity of the price of a bond or a fixed-income portfolio to changes in interest rates.

Floating-Rate Note 
A debt instrument with a variable interest rate.  Also known as a “floater,” a floating-rate note’s interest rate is tied to a benchmark such as the US Treasury bill rate, LIBOR, or the Fed funds or prime rate.  Floaters are mainly issued by financial institutions and governments, and they typically have two-to five-year terms to maturity. They typically carry lower yields than fixed notes of the same maturity. The rates for floating-rate note reset or adjust periodically,  normally on a daily, monthly, quarterly or semiannual basis. 

MSCI All Country World Index (MSCI ACWI)
A free-float weighted global equity index that includes companies in 23 emerging market countries and 23 developed market countries and is designed to be a proxy for most of the investable equities universe around the world.

Sharpe Ratio
A measure for calculating risk-adjusted returns that has become the industry standard for such calculations. It was developed by Nobel laureate William F. Sharpe. The Sharpe ratio is the average return earned in excess of the risk-free rate per unit of volatility or total risk. The higher the Sharpe ratio the better.

Yield
The income produced by an investment, typically calculated as the interest received annually divided by the investment’s price.