Investors often ask us which of the two primary bond market risks—interest rate or credit—they should focus on in 2017. Our answer? Both of them—and the interaction between the two.
Fixed-income investors know, of course, that they must manage both types of risk. And both pay off over time, because investors who take more risk are compensated with higher returns.
But usually, the two types of risks don’t pay at the same time. After the global financial crisis, for instance, the most important variable for bond markets was central bank policy. With inflation having evaporated and interest rates at record lows, interest-rate risk—also known as duration risk—wasn’t much of a concern. Investors could afford to focus more intently on credit quality.
That’s not true anymore. Central banks are still important, but they’re one factor among many. And they’re not just pumping liquidity into the system anymore. The Federal Reserve has already hiked rates twice and the Bank of Japan is now focused on targeting the yield curve. In addition, governments are moving toward more expansionary fiscal policies, which could stoke inflation—particularly in places like the US, where the economy is at full employment.
At the same time, valuations look rich in many corporate bond markets, and credit cycles are diverging across sectors and regions, with some nearing the end of a multiyear expansion.
In other words, interest-rate and credit risk are equally important today. Both require constant attention. In a way, that’s a good thing. Markets are healthier when there are multiple variables that can influence prices. But they’re also more volatile and less predictable.
BALANCING OUT YOUR RISKS
That’s where a barbell approach can come in handy. Barbell strategies balance risk by pairing interest-rate-sensitive government bonds with high-yielding credit assets.
They work well because they blend asset classes whose returns are usually negatively correlated; government bonds—known as risk-mitigating assets—tend to do well when growth slows, while return-seeking assets such as high-yield corporates shine when growth accelerates and interest rates rise.
Strong returns on one side of the barbell can outweigh weakness on the other. For instance, during the global financial crisis, a rally in government bonds compensated investors for weakness in financial-sector corporate bonds and other credit assets.
Just as importantly, the negative correlation between the two lets investors rebalance their portfolios by selling the outperformers on one side of the barbell and buying the underperforming bonds on the other.
Over time, we’ve found that a 65/35 split between risk-mitigating assets such as global treasuries and return-seeking ones such as high yield or emerging-market debt can minimize large drawdowns (Display) while still providing a high and steady stream of income.
Occasionally the prices of government bonds and credit rise or fall at the same time. But such occurrences are rare and usually brief.