Investment Case for Bonds: The Tale of a Three-Legged Stool

Fixed income usually plays an important role in an investor’s overall asset allocation strategy. The investment rationale for bonds is typically grounded in at least one of three reasons: (a) to produce predictable income, (b) to diversify overall portfolio risk, and (c) to preserve capital. Over the past 15-plus years, this three-legged stool of support has rarely been balanced (See Figure 1).

Bond yields experienced a multi-decade secular decline that was exacerbated by global central banks’ unprecedented expansionary monetary policy response to the Global Financial Crisis (2007 through 2009) and the COVID-19 pandemic (2020 through 2021). The persistent low interest-rate environment provided the desired and necessary economic stimulus, but weakened the income leg of the stool, pushing some investors to take greater risks and stretch for yields.

The era of easy money ended in 2022, when inflation-induced Federal Reserve (Fed) tightening sharply moved rates higher, pushing bond and equity prices lower. While the income leg stood strong, the diversification benefits of fixed income that investors could typically count on did not pan out. The great monetary policy reset marked the first time in 45 years that both stocks and bonds recorded annual losses, as measured by the  S&P 500 Index¹ and the Bloomberg (BBG) U.S. Aggregate Bond Index,² respectively.

Being a bond manager over the last 15+ years required supporting the investment case for bonds with only two sturdy legs of the three-legged-stool. Looking ahead, with real and nominal yields approximating historical averages, the case for increasing allocations to high quality investment grade bond portfolios is more compelling than it has been in a long time. 

Psst! We May Have Found the Yields You Have Been Looking for … 

The future is uncertain, and capital market assumptions that drive portfolio allocation decisions need to account for that uncertainty. The level of confidence around outcomes that we can assign to any one financial instrument varies greatly across the asset  class spectrum. 

With that in mind, we know that high quality investment grade bonds rarely deliver surprises. While, the value of fixed income investments is sensitive to interest rate moves, there is a big difference between unrealized losses, which many investors experienced in 2022, and permanent loss of capital. Graham and Dodd³ referred to bond investing as a “negative art,” meaning that, as long as bonds do not default, the yield at which you buy them, will be the return you get: no less … no more. In other words, historically there has been a strong relationship between yields and subsequent returns on high quality investment grade bonds (See Figure 2).

For nearly a decade and a half, yields on investment grade bonds hovered around very low single digits, resulting in low forward-looking return expectations. For many private clients and institutions, there may have been a tendency to over-index allocation decisions based on expectations derived from historical averages.

For example, during this 15+-year era of easy money due to low interest rates, traditional 60/40 stock/bond investors looking for 6 to 7 percent returns had to think outside the box. With bonds at times yielding 2 percent on 40 percent of the portfolio, one would need to earn returns in excess of 10 percent on the remaining 60 percent to achieve the stated objective. As a result, to get bond-like returns, many investors had to stretch for yield, by reducing allocations to investment grade fixed income, while increasing exposure to new and different types of risk.

In many instances, investors increased exposures to private credit and other alternatives to approximate bonds’ historical role in a diversified portfolio. Moving forward, investors may once again seek income, diversification, and capital preservation by returning to corporate, municipal, and government bond markets that are offering the highest yields in 15 years. The bottom line, in our view, is that with current yields approximating long-term historical averages, investors can more confidently rely on investment grade bonds to get bond-like returns. 

If Current Bond Yields Alone Don’t Tip the Scale, Disappearing Equity Risk Premia May 

For over a decade, the Fed provided ample and cheap liquidity, which often rewarded companies for leveraging balance sheets and taking more risk. With the era of easy money fading in the rear view mirror and the Fed tightening cycle coming to an end, a more favorable rate environment is improving investor sentiment towards investment grade fixed income. 

One of the key reasons behind the positive sentiment shift is related to how attractive bond yields are relative to where they have been for the last 15+ years. The other is that earnings yields on equities and yields on nominal bonds have converged for the first time since the DotCom⁴ bubble from the early 2000s (See Figure 3).
 

We believe relative valuations in the current market favor bonds, as investors are unlikely to get adequately compensated for taking equity risk. 

To Extend or Not to Extend, That Is the Question

Every trade consists of a buy and a sell decision, and the need to make those decisions quickly and concurrently has been a necessity during the era of easy money. Simply stated, sitting in cash for too long when rates on cash-like instruments were close to zero likely resulted in a drag on investment performance.

But that all changed in July of 2022, when the U.S. Treasury yield curve inverted, pushing short-term bond yields higher than long-term yields. By July 2023, the disparity reached its widest margin since 1981.⁵ Figure 4 illustrates periods of time when 10-year yields for Treasuries exceeded 2-year Treasury yields (above the 0 on the y-axis) and when 2-year yields exceeded 10-year yields (below the 0 on the y-axis). The latter has typically incentivized investors to stock up on Treasury bills or park sale proceeds and deposits in cash and its equivalents. 

Mark Twain stated that “history never repeats itself, but it often rhymes.” While no curve inversions or recessions are precisely alike, there are some interesting observations investors can glean from past business cycle transitions that could be useful in informing duration extension decisions. 

To help illustrate the point, we analyzed historical stock, bond, and cash returns going back to the 1980s, encompassing the last six economic recessions. During the period studied, most notably, there have only been three years in which cash outperformed the other asset classes, and 13 years in which cash performed better than the BBG U.S. Aggregate Bond index.

Given the current market backdrop, we isolated returns on each representative asset class or portion of the bond market over four different market regimes during recessionary periods recorded from January 1, 1980 through September 30, 2023. The market regimes were:

1.  from the first inversion of the yield curve through the start of the recession that followed,
2.  from the first inversion to the end of the recession that followed, 
3. for the period of six months after recession onset, and 
4. during the recessionary period 

As shown in Figure 5, we found that cash as represented by 3-month T-Bills,⁶ as measured by the FTSE 3-Month U.S. T-Bill Index,⁶ had the lowest average historical returns when compared with longer duration investment grade proxies (i.e. BBG U.S. Aggregate Bond,² BBG U.S. Government Bond 1- to 3-Year,⁷ and U.S. Treasury: Long indices⁸). Our results indicated that sitting in cash, as represented by 3-month Treasury bills, for too long would have been risky from an opportunity-cost perspective, unless regime transitions could have been timed correctly. 

Thus, we feel the question on duration extension is less about if and more about when, meaning that moving out of cash and extending duration may be the next big step for many investors. Inverted yield curves create temporary investor inertia and hesitance to extend duration, increasing the appetite to want to time the market, but getting the timing right can be difficult, and getting it wrong can be costly. Given that investment committee decision-making speed is not as fast as market speed, the risk of missing out and managing regret is real. 

[1] The S&P 500 Index consists of 500 stocks chosen for market size, liquidity, and industry group representation. It is a market-value-weighted index with each stock’s weight in the index proportionate to its market value. You cannot invest directly in an index.

[2] The Bloomberg U.S. Aggregate Bond Index is a broad-based benchmark that measures the investment-grade, U.S.-dollar-denominated, fixed-rate taxable bond market, including Treasuries, government-related and corporate securities, mortgage-backed securities (agency fixed-rate and hybrid adjustable-rate mortgage pass-throughs), asset-backed securities, and commercial mortgage-backed securities. You cannot invest directly in an index.

[3] Security Analysis, Benjamin Graham and David Dodd, McGraw-Hill, 1934.

[4] The DotCom bubble was a rapid rise in U.S. technology stock equity valuations fueled by investments in Internet-based companies during the bull market in the late 1990s. The value of equity markets grew exponentially during this period. The bubble burst between 2001 and 2002, with equities entering a bear market.

[5] https://www.cnbc.com/2023/07/07/yield-curve-inverted-the-lowest-since-1981-what-it-means-for-yo.html

[6] The FTSE 3-Month U.S. T-Bill Index is intended to track the daily performance of 3-month U.S. Treasury bills. You cannot invest directly in an index.

[7] The Bloomberg U.S. Government 1-3 Year Index is a board-based benchmark that measures the non-securitized component of the U.S. Aggregate Index. It includes investment grade, U.S. dollar-denominated, fixed-rate Treasuries, and government-related securities with maturities between 1 and 2.9999 years. You cannot invest directly in an index.

[8] The Bloomberg U.S. Long Treasury Index measures U.S. dollar-denominated, fixed-rate, nominal debt issued by the U.S. Treasury with 10 or more years to maturity You cannot invest directly in an index.

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