By Peter Coffin
In this landscape for fixed income markets, risk avoidance reigns supreme.
Hello, this is Natalie Baker, vice president of marketing at Breckinridge and welcome to the Breckinridge podcast. Today, I'm joined by Breckinridge's president, Peter Coffin, and I'm really excited about the call today. You know, most of us know the traditional reasons why you invest in fixed income, but today Peter is going to take us a step beyond that and discuss some of the less obvious reasons for owning bonds, especially in today's environment. So Peter, we've seen a lot of volatility recently, particularly in December and going into January. Can you give us some additional color on what we've seen in markets as of late?
Thanks, Natalie. Yes, yes indeed, we have seen a lot of volatility in 2018 and it actually started way back in February 2018 when there were some imbalances as a consequence of a trade related to the VIX that drove equity prices down quite precipitously. They bounced back but then again in December we saw quite a bit of volatility, and I think what's interesting is that it seemed unrelated to the fundamentals of the economy at the time, and instead, more of a function of imbalances and dislocation that was created by some model-driven quantitative, momentum trading, probably the growth in the ETF's and passive strategies could play into this, and just some general challenges in liquidity across different markets that were noted. So I do think that December was a challenging time for the markets and a period of heightened volatility that seemed unrelated or unconnected to the fundamentals of the economy.
I see. So in this new era of heightened volatility, when fundamentals are seemingly detached from market prices, are there any implications from an investment standpoint?
Well, I would say there are definitely implications because volatility is challenging for investors to cope with and the most important thing for investors is to be patient, be rational, think long-term. We're all long-term investors but, unfortunately, by necessity we're short-term evaluators and in the short-term things can look pretty unsettling and investors can have a hard time dealing with that. Behavioral finance is a field that has grown quite a bit over the last few decades and there's been some great work that points to how investors are not machines, that they really struggle with loss aversion and hurting and hubris and so the challenge, I think for an investment strategy and allocation, is in this period of heightened volatility that seems a little less predictable and a little less tethered to underlying economic fundamentals, is helping investors cope with that volatility and keep focused on the long-term.
So it makes intuitive sense to me that investors may be challenged to be patient when markets are volatile. So how can fixed income help investors cope with short-term volatility?
I think there are really two ways that a fixed income portfolio helps investors cope with volatility, and the first is well understood and within modern portfolio theory, and that is that high quality bond prices tend to benefit from flight to quality in a risk-off market. That is, investors who are nervous and selling risk assets like equities tend to seek out bonds, high-quality bonds. Bonds, first of all, have more reliable and predictable cash flow but they're also higher in the capital structure, so bond prices tend to go up and that offsets or counterbalances the decline in equity prices.
And I think most investors know that fixed income plays that role.
Yes. I would agree, but the second way goes a little beyond that into the field of behavioral finance and I would argue that one of the benefits for investors of investing in a portfolio of bonds directly is that they can derive a return from the cash flow from the coupon and the principal payments that is earned independent of the market. And as a consequence they can focus beyond short-term market fluctuations and volatility and look to that reliable and predictable cash flow, making them less beholden to market returns and giving them somewhat of a haven from that short-term volatility.
So this is a really interesting perspective, bringing behavioral finance in as an argument for fixed income. Is there any data or research that you have connected to this perspective?
Well, there is, I believe. First, Richard Thaler, one of the leading economists in behavioral finance, has done some studies, not about bonds directly, but one of the studies he did related to what's called "myopic loss aversion", which simply noted that investors that obsess about short-term market prices have weaker performance than those investors who are actually kept in the dark on market performance and as a consequence, by necessity, focused more on long-term returns. So I would argue that bond portfolios, while not keeping investors in the dark, do help by virtue of generating a reliable, predictable long-term cash flow and thereby enable an investor to cope with market dislocation more effectively.
These cash flows essentially make it less likely that an investor would panic when they see short-term volatility occurring.
Exactly. And the other thing that supports this case is just looking at those investors in bonds that lack that predictable, reliable cash flow including a principal payment and that would be investors in bond funds because the bond fund is a share in a bond portfolio and has no maturity date. So lacking that maturity date, we see that investors in bond funds are much more apt to head for the exits to redeem their shares or sell their shares in the bond fund in periods when market prices are going down. In fact, that's pretty well-documented by looking at the ICI data or the Fed flow of funds data. And interestingly, you also see plenty of evidence that, at the same time that bond fund investors tend to head for the exits as interest rates are rising and bond prices are going down, individuals tend to be buying bonds directly, so holders actually increase their holdings which would support the case that those owning bonds directly are better able to weather periods of volatility.
All right, Peter, this is all really interesting. Is there anything more you'd like to say to sum everything up?
Well, I'd like to just emphasize that none of what I've suggested about the value of holding bonds directly and earning a cash flow and deriving a return independent of the market is to diminish the importance of looking at market returns and relative returns and all the analysis and attention that we give that at Breckinridge. It's very relevant and very important. I am simply saying there's been a lot of work and good research on behavioral finance. I think we understand that investors are not machines and I think looking outside the box of modern portfolio theory is helpful and I think that a bond portfolio can be better understood with that perspective.
Well, thanks, Peter.
We hope that you in the field have found this informative and for more information, please see Peter's companion blog post which is located on our website. Have a great day.
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