Jeff Raupp, CFA, Senior Investment Manager
Now that we’re able to look back with the benefit of hindsight, it’s pretty easy to pick on the mistakes that investors made during the financial crisis of 2008. For instance, as equity markets sold off, emotion took over, and many investors that entered the crisis with a well balanced portfolio abandoned their plan and made wholesale changes to fixed income or, even worse, cash. At the time, it seemed like a rational reaction—Wall Street institutions that had existed for decades were insolvent, and each day seemed to bring a new, ineffective government program to stabilize the credit markets, along with yet another triple-digit loss in the stock market.
We know now that what had started as an economic slowdown and then recession extended into a full-fledged market panic, where investors sold indiscriminately of price. In the years that followed, those that kept their heads recovered and reached new highs with their investments; those that joined the panic are, in many cases, still hoping to recover their 2008 losses.
Today, many investors are considering a question that could very much have the same negative long-term consequences, namely, “Should I abandon fixed income altogether?”
The question comes up after interest rates spiked in reaction to Federal Reserve Chairman Ben Bernanke’s May testimony in which he outlined a scenario where, with the right economic growth in place, the Fed could start lowering the level of bond purchases they’re making as part of the quantitative easing (QE) program. Over a two month period, the yield on the 10-year Treasury jumped from 1.6% to 2.8% and at -2.3%, the Barclay’s Aggregate Index had its worst quarterly return since the second quarter of 2004 when it fell 2.4%.
To answer the question, first let’s look at the downside potential. It’s been a long time since we went through an extended rising rate environment. As our research indicates, from 1945 to 1981 the yield on the 10-year Treasury rose from 1.5% to over 14%. Over that 36-year period, the return an investor in the 10-year Treasury received was actually a positive 2.8%, with 75% of the calendar years in that period having positive returns. The worst one-year loss, 5.0%, was in 1969, and the worst multi-year losing streak happened twice—1955-1956 and 1958-1959 (1957 was a strong year and the five-year period 1955-1959 was close to flat). Compared to a stock market bubble, the downside on fixed income is extremely tame.
Secondly, you have to think about the role fixed income plays in your portfolio. In heavy stock market sell-offs, fixed income is often the only asset class with positive returns and therefore can act as a hedge against market volatility. Since 1945, there has only been one year (1969) where both stocks and bonds had negative returns. In today’s world, a global flight to safety results in demand for high quality fixed income, driving yields down and bond prices higher. No other asset class plays the low volatility hedging role quite as well. Responding to the threat of low rates by greatly increasing equity, or even alternative exposure, can prove disastrous if markets crater.
Finally, fixed income comes in many varieties. At any given point in time, there are areas of fixed income that provide opportunity and/or protection. By broadening your universe beyond simple treasuries to take advantage of these you can get a better end result.
Let’s be clear, core, investment-grade fixed income doesn’t provide a great investment opportunity right now. With yields still at low levels and likely to rise in the coming five to ten years, we’ll likely see muted returns at best with fits and starts of performance along the way. Inflation is currently in check below 2%, but if we started to see it flare up, investors, especially those with longer horizons, would need to consider the impact rising prices would have on their purchasing power. But even in an adverse environment, fixed income still plays an important role in portfolios.