March saw continued market volatility, the expected bump higher in policy rates and stable muni credit conditions.
Market participants often debate the optimal measures of performance for fixed income strategies. These deliberations occur because investors have various objectives, and these objectives lend themselves to different measures of risk and performance. In the Martin L. Leibowitz and Sidney Homer classic “Inside The Yield Book,” the various investment objectives are grouped into three categories: total return; immunization, also known as liability-driven investment (LDI) and asset-liability matching (ALM); and passive/laddering. Here, we discuss these objectives in the context of high-grade bond investors. Our view is that all three objectives are relevant in varying degrees for retail and institutional bond investors.
The Total Return Objective
One of the most familiar investment objectives is to maximize total return, which represents the overall market return of a given period. Fixed income market returns have strongly benefited from the trend of falling interest rates for much of the past 30-plus years. As a result, it’s not surprising that high-grade bond investors have adapted to focusing on total return, viewing bonds as a vehicle of wealth creation versus wealth preservation.
As markets enter a new environment with potentially rising rates, it is worth reconsidering what is the most useful perspective on total return performance. In this new market setting, total returns may not replicate the stellar performance of the past three decades. We believe that total return will remain significant in the new landscape; however, the lens for viewing market performance has shifted. While there will still be opportunities to add value and generate favorable returns with high-grade bonds, investors are likely to focus more on a bond portfolio's ability to act as a counterbalance to volatility in the broader market.
Not all returns are created equal; the marginal utility of returns for investors can vary, partly depending on risks in the broader market environment. High-grade bond strategies are well suited to deliver solid returns when they matter most: when risk is out of favor and riskier assets, such as equities, are performing poorly. In assessing total return, investors should evaluate how well a high-grade bond strategy is counterbalancing ongoing market risks.
Looking Beyond Market Return
While total return offers valuable insight, there is a growing understanding that simply evaluating market return will not adequately depict investors objectives and risks. Almost all investors, both retail and institutional, have specific liabilities to meet over the short, medium and long terms, and they examine risk and return relative to those requirements.
Investors with a specific liability in the future will often aim to match their incoming cash flows with their future payment requirements. These liability-driven investors choose not to rely on market returns to fund liabilities, as markets can be fickle and may not reliably fund future obligations. For these investors, the largest investment risk is the failure to meet a future obligation.
Other investors want to create an income stream to fund future or ongoing cash flow needs, but they do not have a specific liability in the offing. These investors often implement passive/laddering strategies to achieve positive returns versus inflation. Bond ladders can create a diverse maturity structure that is long enough to provide positive returns versus inflation, but not so long that an investor risks locking in negative real returns with a significant rise in inflation. Passive laddered strategies diversify reinvestment risk and thereby can help to hedge inflation risk for all investors.
Coping with Market Risks
In recent decades, investor focus on total return and market performance has overshadowed cash flow returns on high-grade bonds. Of course, total return is still important, as market return can help gauge a portfolio's ability to sustain an income stream or provide a counterbalance to riskier assets. However, for liability-driven or passive/laddering objectives, a focus on cash flow returns is paramount. By earning predictable and reliable coupon returns and receiving principal at maturity, liability-driven and passive/laddering investors can mitigate the risks of not meeting future obligations. All three objectives provide coping mechanisms for market risks.
We believe that all three objectives are relevant to most high-grade bond investors in some way, and thus should be considered as important measures of return. Most investors have future funding/cash flow needs and various time horizons to consider, and they must be thoughtful about their objectives and the measure of performance in their fixed income allocations. We look forward to continued discussions with clients on their investment goals.
DISCLAIMER: This material has been prepared for our clients and other interested parties and contains the opinions of Breckinridge Capital Advisors, Inc. Information and opinions are current as of the date(s) indicated and are subject to change without notice. Any specific securities or portfolio characteristics are for illustrative purposes and example only. They may not reflect historical, current or future investments in any client portfolio. Nothing in this document should be construed or relied upon as tax, legal or financial advice. All investments involve risk including loss of principal. An investor should consult with an investment professional before making any investment decisions. This document may include projections or other forward-looking statements, which are based on Breckinridge's research, analysis, and assumptions. There can be no assurances that such projections will occur and the actual results may differ materially. Other events that were not taken into account in formulating such projections may occur and may significantly affect the returns or performance of any account. Past performance is not indicative of future results. This document includes information from companies not affiliated with Breckinridge (third party content). Breckinridge reasonably believes the third party content is reliable but cannot guarantee its accuracy or completeness.