Bonds for a rainy day?
RICH CONSUL, CFA 30-Mar-2021
For months now there has been chatter about rising rates and the impact they might have on bond portfolios. Don’t look now—but a major move in Treasury yields has already occurred. How much further will rates move and how quickly? And more importantly, is there a way for investors to play defense while still capturing attractive yields?
We believe that an allocation to convertible bonds—and more specifically high-quality, investment-grade convertibles—merits consideration as part of a diversified, core-plus fixed income portfolio.
Consider the challenges facing investors in the current environment. On one hand there’s the worry of rising interest rates. On the other hand, many investors still need income and are looking to trade some risk for higher yields. In such a typical core-plus strategy, it’s not uncommon to allocate 10 to 20% of the portfolio to high-yield corporate bonds. This is the conventional “plus” in the strategy—a calculated stretch for yield whereby investors accept higher credit-event risk in the hopes of higher portfolio returns.
However, there might be a better way. This pandemic and the massive fiscal and monetary response from the both Congress and the Federal Reserve have skewed the current investment environment and may have shifted the calculus for that risk-reward tradeoff. Among the critical steps taken to revive the economy and shore up seizing financial markets during the worst of the COVID crisis, the Federal Reserve pledged to buy high-yield corporate bonds (via direct purchases and ETFs). This unprecedented step certainly increased liquidity, but it also has skewed spreads and pricing. Do fundamentals matter anymore, and what happens when the Fed starts to taper their bond purchasing activity as they did in during the 2013 “Taper Tantrum?” Already, high-yield spreads have fallen below pre-COVID levels as of mid-March. Investors need to acknowledge this dislocation when building their fixed income portfolios.
Moreover, Congress’s fiscal stimulus, as well as the Fed’s stated commitment to allow inflation to exceed its 2.0% target, should give investors pause regarding the future trajectory of interest rates. With all the stimulus, how much further will Treasury yields need to jump in order to attract buyers? And will rising yields usher in a new era of inflation?
The yield on 10-Year Treasuries has already more than doubled from August 2020 to March 2021. Investors may want to consider how their higher-yielding fixed income assets have performed during this period, and specifically compare them to high quality (i.e. investment-grade) convertible bonds.
We believe that the performance of investment-grade convertible bonds in the most recent rising rate period is not an isolated event. In fact, we analyzed and compared the interest rate sensitivity of three fixed income categories: 1) high-yield bonds 2) investment grade convertible bonds 3) traditional fixed income portfolios (i.e. the Bloomberg Barclays U.S. Aggregate Bond Index) in nine intervals since 2000 when the 10-year US Treasury yield increased by over 100 basis points (bps). The accompanying graph tells the story.
During the nine rising-rate periods analyzed, investment-grade convertibles provided better returns on average than high-yield or traditional fixed income assets. We believe that this data clearly illustrates the beneficial nature of including a slice of investment-grade convertible bonds as part of a core-plus solution. In addition, it’s also worth noting that investment-grade convertibles currently offer incremental yield over either the yield of the Bloomberg Barclays U.S. Aggregate Bond Index or the dividend yield of the S&P 500, while insulating against rising interest rates (as of late March 2021).
We can all agree that the current environment is tricky for fixed income investors. Rising rates create potential headwinds that may put principal of a conventional fixed income portfolio at risk. But history has shown that convertibles are a better hedge against possible drawdowns caused by rising rates, while also offering greater upside potential versus the typical high-yield portfolio strategies.