Dan Williams, CFA, CFP, Investment Analyst
People need no help picturing equity return volatility. Anyone invested in the equity market in the middle 2000s still likely feels the scars from the subprime mortgage crisis. Prior to that, there was the dot com burst of the early 2000s. The dark side of equity return volatility is double-digit loses in a short period of time that can take years to recover. It is for that reason equity investing is best for time horizons that are also double-digit in years. However fixed income volatility is more subtle in nature and although people know to try to avoid it, it is not as widely understood.
Volatility for investments is often represented by the standard deviation which most understand has to do with the range of returns that are experienced around the average return. However, knowing the term and understanding what the term represents are two separate matters. Volatility in traditional fixed income securities is driven by the two factors: changes in the rates that securities of similar risk should pay and how long you are locked into receiving the coupon rate of a given security. The magnitude these market rates changes impact the principal value of the fixed income instrument is driven by how long an investor is locked into a given rate as the duration of a bond. Accordingly, the fear of rising raters has driven investors to try to lower the duration of the bonds they own to lower the price hit or even to avoid fixed income securities.
One thing that differs between equity and fixed income volatility is what happens with returns after there is a downward movement in price. When an equity goes down in value it is likely due to the consensus judged future prospects of the equity having gone down. For a fixed income, as long as the future ability of the instrument has not come into serious question, the short-term hit comes due to the market view of rates required for payments having increased. In other words, equities go down because things have gotten worse while for fixed income prices go down because the market feels you should be paid a higher rate going forward.
As way of example, consider a diversified portfolio of bonds like that represented by a Bloomberg Barclays US Aggregate Bond replicating investment like the iShares US Aggregate Bond ETF (AGG) or the Vanguard Total Bond ETF (BND). Currently, the duration is about 6 and the 30-Day SEC Yield is about 3%. If rates rise by 0.5%, these securities will take about a 3% price hit (not precisely due to convexity but close enough). Going forward the SEC Yield should rise as bonds now are lower priced but pay the same coupon amount and new bonds are bought with higher coupons. The income return on a new dollar invested is now expected to be over 3% but a 3% hit was taken on the principal amount invested. Despite the feared rate hike occurring, the net return is still projected flat or maybe even slightly positive for the 12-month period.
Another way to picture this return volatility, we can look at the actual annualized 36-month, 84-month, and 120-month rolling periods for the Bloomberg Barclays US Aggregate and Russell 3000 Index since the start of 1994, 25 years ago. During this period there existed no 36 month period where Bloomberg Barclays US Aggregate failed to deliver a positive absolute return and as increasingly longer periods are looked at the range of actual outcomes settles into a 3% to 8% range. Alternatively, equity still possesses a few very unlucky 120-month (10-year) periods with a negative return as well as periods of annualized returns in excess of 14%.
It is for this reason that longer time horizons are prescribed for equity investing and time horizons of 3+ years are regarded as reasonable for holding a diversified fixed income exposure. Finally, it would not be an investment blog if it was not pointed out that these extreme return periods often occur at different times for different asset classes and intelligent diversification gives better return range confidence. Better investment return confidence leads to increased ability to plan and better planning usually leads to better outcomes.
The views expressed are those of Brinker Capital and are not intended as investment advice or recommendation. For informational purposes only. Brinker Capital, Inc., a registered investment advisor.