This article was originally published in November 2013.
When I started in the investment business, equity portfolio managers had shinier shoes than bond managers. Analyzing financial statements and calculating interest coverage ratios partly explained the personalities of these people in rumpled suits.
The persistent bear market in bonds since the end of World War II had beaten participants into an attitude of resignation. Then something changed. Double-
digit interest rates and inflation in the early 1980s crushed the value of bond portfolios, rendering many financial institutions technically insolvent. An asset, taken for granted as ballast on balance sheets, was suddenly in focus.
Only people older than 50 remember this transition. Bonds have since enjoyed a 32-year bull market, with only occasional interruption. Bond managers could do little wrong, and were now dressing as sharply as their counterparts in the equity space. But few believe the next 30 years will be the same as the last. Extending duration, leveraging sector spreads and lowering quality to pick up yield will not be enough. Welcome to the “new” old bond market.
Whether rates increase immediately or not, the risk/reward for bonds looks troubling. Chart 1 shows three possibilities:
- an upside if interest rates fall to zero (a depression);
- a downside using the average yield over thirty years;
- a downside of moving to half the average yield over thirty years.
Bonds are not necessarily the low-risk asset class portrayed in textbooks, and capital markets seem to have anticipated some of this back up. Chart 2 shows the same scenarios applied to popular strategies with ETFs in each category shown in Table 1. Long-term bonds already appear to be at half their 30-year average yields.
Traditional benchmarks are increasingly useless to investors. Who cares how a manager does against the DEX universe? Only preserving capital and generating income matter. For a 60% equity 40% bond portfolio, it’s unclear which will be the riskier asset class over the next few years.
In rising-rate environments, keeping duration short mitigates losses. ETFs offer two approaches: floating-rate notes, available in both an active (HFR) and passive (XFR) version; and senior loans, also available in active (FSL) and passive (BKL). The duration of each of these instruments is less than one year.
Aternative sources of yield for consideration include emerging markets debt, high yield, real return, REITs, preferred shares and structured solutions like private debt, and infrastructure. Many of these strategies are represented by ETFs. Breaking down the component parts of the fixed-income equation and returning to the trading approach of an earlier era may prove useful to bond managers in the future.
Thirty years ago, the focus was on continuously improving the quality, term and yield of a bond portfolio. If interest rates are heading higher, taking the best the market will mean abandoning benchmarks and being actively opportunistic. Buy and hold may not be good enough anymore.
Table 1 Selected Bond ETFs
Category listings by AUM
|1 to 5 YEAR LADDER|
|iShares 1-5 Year Laddered Corporate Bond Index Fund||CBO||0.28%||3.00||2.40%|
|iShares 1-5 Year Laddered Government Bond Index Fund||CLF||0.17%||2.98||1.74%|
|PowerShares 1-5 Year Laddered Corporate Bond Index||PSB||0.25%||2.98||2.50%|
|Powershares Long Term Government Bond||PGL||0.25%||13.90||3.66%|
|iShares DEX Long Term Bond||XLB||0.35%||13.29||4.04%|
|iShares DEX Universe Bond Index||XBB||0.33%||6.63||2.77%|
|BMO Aggregate Bond Index||ZAG||0.23%||6.65||2.71%|
|Vanguard Aggregate Bond||VAB||0.26%||6.90||2.70%|
|Horizon Active Canadian Bond||HAD||0.42%||6.78||3.09%|
|iShares DEX Short Term Bond||XSB||0.28%||2.73||1.83%|
|BMO Short Corporate Bond Index||ZCS||0.30%||2.77||2.30%|
|BMO Short Federal Bond Index||ZFS||0.20%||2.59||1.43%|
|Vanguard Canadian Short-term Bond Index||VSB||0.19%||2.70||1.80%|
|Vanguard Short-term Corporate Bond Index||VSC||0.18%||2.80||2.40%|
Table 2 Defensive Bond Strategies
Category listings by AUM
|Horizon Active Floating Rate Bond||HFR||0.40%||0.53||2.48%|
|iShares DEX Floating Rate Note||XFR||0.22%||0.15||1.24%|
|Powershares Senior Loan (CAD Hedged)||BKL||0.80%||0.25||5.35%|
|First Trust Senior Loan (CAD Hedged)||FSL||0.85%||0.41||5.64%|