With yields near zero, many investors may question the value of fixed income within a portfolio. Western Asset’s Head of Product Management, Doug Hulsey, joins our Head of Equities, Stephen Dover, to discuss fixed income investing with an active-management lens. He makes a case for the asset class for investors in light of market uncertainties and outlines where he sees opportunities today.
Here are highlights from their conversation
- “The announcement of these vaccines has been tremendously supportive of the capital markets. The bond market certainly has taken it positively, and the bond market is pretty good at predicting what’s going to happen to the economy several months out. I think the bond market likes what it sees right now.”- Doug Hulsey
- “What appears to have transpired is probably the best scenario for the fixed income markets, and that is divided [US] government. It would appear as though the Republicans will retain the Senate and the presidency will be assumed by President-elect Biden, the House remaining with the Democrats. This is a pretty good outcome from a market predictability standpoint.” – Doug Hulsey
- ”Fixed income continues to generate a reliable source of income for investors and in a world starved for income sources. If you look at the volatility…in fixed income, it’s roughly 25% of the volatility that you get in the equity market. So, while equities are certainly an integral part of any reasonable asset allocation mix, fixed income has, and always will be, a part of any diversified portfolio. This COVID example was a stark reminder that you need diversifying assets in your portfolio.” – Doug Hulsey
Stephen Dover: Welcome, Doug.
Doug Hulsey: Thank you, Stephen.
Stephen Dover: So Doug, let’s just start off looking at the fixed income landscape and how your views on the elections have made you think differently?
Doug Hulsey: Leading up to the election, Western did a number of scenarios using different election outcomes, divided government, one government with all blue or all red. But what appears to have transpired is probably the best scenario for the fixed income markets, and that is divided government. It would appear as though the Republicans will retain the Senate and the presidency will be assumed by President-elect Biden, of course, the House remaining with the Democrats. So, against that scenario, I’m looking at the impacts on the fixed income markets. This is a pretty good outcome from a market predictability standpoint.
Stephen Dover: In the short term, the question everybody asks about is the stimulus. So how does what’s happening or not happening on the stimulus affect your thinking around fixed income?
Doug Hulsey: Yeah, it’s very important. Obviously, the stimulus programs early on in the COVID pandemic were actually very beneficial to the markets. If you look at the corporate credit facility that the Fed [US Federal Reserve] announced early on in COVID, which was highly supportive to the credit markets, after credit spreads have widened out quite considerably, that was a very promising and supportive sign to the credit market, and certainly provided some stability to that market that had otherwise experienced a lot of instability and credit spreads widening.
Stephen Dover: Of course, election results are very important, but for us in the investment markets, the reserve banks are incredibly important, perhaps even more important. How do you see the Federal Reserve’s role based on the election, or what do you see going forward with the Federal Reserve?
Doug Hulsey: When you think about the Fed, Chairman Powell came out and said that they’re willing to be highly accommodative for an extended period of time, even inferring that they would be willing to be accommodative even if inflation were to tick up. As bond managers, we’re concerned about rising interest rates because that erodes the principal value of fixed income investments. But when you have a Fed come out and say, it’s going to be highly supportive of a market, lower for longer, that provides a lot of stability to the fixed income markets and some predictability. The announcements by the Fed have been incredibly supportive. They’ve obviously really stabilized the markets. You’ve seen the tremendous rally in equities over the last few months as the economy has continued to recover. And, actually we’ve seen bonds, bond yields back up since they touched a low of 99 basis points1 in early March. Today we’re around 1.62% on a 30-year [US Treasury] bond. So, they have backed up somewhat, but still historically low, but the Fed has been incredibly supportive and certainly adds some element of predictability with managing bond portfolios.
Stephen Dover: Those low rates have been very positive for the equity markets as well, which also discount future income streams, very similar to fixed income. The big debate that people seem to have is about inflation. Of course, many classical economists have predicted inflation for a long time now, and we haven’t seen it. What’s Western’s view on inflation over the next year or two?
Doug Hulsey: If you think about the last almost 40 years, interest rates have been in a massive decline. And certainly, as I mentioned earlier, the 30-year rate hit 99 basis points, a historical low, in March of this year. So, in terms of inflation, we haven’t seen evidence of inflation certainly here in the States, and we think that’s going to remain the case. Obviously, inflation is a negative event for the bond markets, but we see a Fed being incredibly supportive. Certainly, we haven’t seen any signs of any material uptick in inflation, again, which is very supportive for fixed income markets.
Stephen Dover: So, turning to the other good news we’ve had in the last couple of weeks, and that’s the vaccine coming out, may come out as soon as the end of the year. How does that affect your outlook? And maybe just tied to that, how, and when, might you see an economic recovery coming?
Doug Hulsey: I’m going to address that, but if you think about the day after the election and it became somewhat apparent that we were going to have divided government, if you examine what the capital markets generated since then, oil prices are up almost 6%. The S&P [500 Index] is up 5%; the Dow [Jones Industrial Average] is up almost 8%; the Russell 200 [Index] is up 10%, EAFEA [Index] is even up 8% and we’ve had a minor back-up in bond yields.2 So, kind of the divided government aspect has been very supportive for the financial markets. Obviously, the COVID vaccine announcements have also been highly supportive. So, you start to see kind of blue patches in the sky here. And you’ve seen capital markets respond positively. You’ve seen a minor back-up in bond yields, you’ve seen credit spreads tighten. So, the announcement of these vaccines has been tremendously supportive of the capital markets. The bond market certainly has taken it positively, and the bond market is pretty good at predicting what’s going to happen to the economy several months out. And I think the bond market likes what it sees right now.
Stephen Dover: We talked a lot about the United States, but of course, if we look globally, it’s really interesting. I still have a hard time getting my head around the fact that virtually 25% of global debt is actually negative yielding. So how do you look at global bonds? I know that’s a small part of the Barclay’s Aggregate Bond Index, but you are a global investor.
Doug Hulsey: If you look at negative-yielding debt on a global basis, a lot of Europe has negative yield, certainly. You’ve had central-bank intervention there in terms of supporting those markets and buying those securities. Negative yields are a bit counterintuitive. When you think about it, generally you think about positive yields that entities have to pay to borrow, and issue debt. So, to invest in securities with negative-yielding securities—it’s a bit counterintuitive. We still think the United States offers one of the most attractive yield curves. Admittedly, when you think about the yields across the US Treasury curve, they are very low still at this point, but on a relative-value basis in a world that’s starving for yield, we still like a lot of the US Treasury, or US fixed income market relative to other global markets. We do see Asia improving, so, we have a bit of a favorable view there. Europe is still kind of coming out of its COVID-related impact on the economy. So, we’re not as positive there, but certainly, we still have a very favorable view.
Stephen Dover: Doug, the question that we’re always asked is how do you think about fixed income in a zero interest-rate environment?
Doug Hulsey: When you think about low interest rates and relatively tight corporate spreads, those are two of the main ingredients that go into valuing the liabilities of corporate pension plans. And certainly, with these extremely low interest rates, it’s caused valuations again, to go materially up. That presents a lot of issues for these corporate chief investment officers trying to manage against the liabilities with interest rates being so low. They need a highly compensated capital markets through equity returns or their other investments to keep up with their liabilities. And it’s been a race that they’ve struggled with, certainly for the last 20, 25 years; the corporate pension pie community is going through a couple of brief moments in time where they were actually close to fully funded status, and they failed to capitalize on de-risking their asset allocation mix relative to their liabilities so that they could maintain a fully funded status.
I know it’s a frustrating game for those chief investment officers out there because the liabilities have been a very difficult race to win for them. And, if you kind of think about the year 2000, pension plans were materially overfunded at that point, but the concept of liability- driven investing or LDI really hadn’t taken hold at that point because interest rates were still pretty high, and certainly high relative to where they are today, and corporate pension plans didn’t really structure their assets toward their liabilities at that point because they had pension plans that were materially overfunded and interest rates that were high, which kept valuations low. But for the last 20 years or so, they’ve been battling an interest-rate environment where rates have been heading lower, corporate spreads remained relatively tight, and capital markets have been not accommodative enough to offset the increase in my abilities that they’ve experienced due to the drop in interest rates. So, it’s been a really tough game for those corporate pension plan sponsors. I feel for them.
Stephen Dover: So, maybe I’ll ask you the same question around individuals. Certainly, most individuals don’t think in terms of liability driven investing, but where does fixed income fit into the individual’s portfolio now with zero interest rates?
Doug Hulsey: Good question, Stephen. And, you know, at the start of the year—let’s just use the 30-year Treasury as an example. At the start of the year, I think the 30-year Treasury hit a high point of around 2.36%, and we had a lot of our investors and even on the retail side, say, “boy, that is really unattractive, I don’t want to invest in that.” But if you fast forward 60 days later, and again, this was at the early stage of COVID, as I mentioned earlier, the 30-year Treasury touched 0.99%. But what people don’t realize is, that represented a 32% return on that Treasury during that compressed timeframe. And you say, “well, why is that the case?” Well, the duration on a 30-year Treasury at this point is about 24, 25 years.3 That’s a lot of duration. That particular security exhibits a lot of sensitivity to changes in interest rates. The point of me telling you this is that the yield doesn’t always give you the best indication of the return potential of that security. And keep in mind, the Barclays Agg [Aggregate Index] continues to exhibit a very low correlation profile relative to traditional risk assets like equities and private equity and hedge funds and so forth. And this COVID example was a stark reminder that you need diversifying assets in your portfolio. And one other thing to keep in mind, when you think about the last 10 years, the Barclays Aggregate has returned 87% total return. Of that 87%, 80% has been generated through the income component of those fixed income securities. So, the price appreciation associated with fixed income for the last 10 years has been fairly negligible. Fixed income continues to generate a reliable source of income for investors and in a world starved for income sources. There again, there is no better solution than fixed income. And if you look at the volatility that you are experiencing in fixed income, it’s roughly 25% of the volatility that you get in the equity market. So, while equities are certainly an integral part of any reasonable asset allocation mix, fixed income has, and always will be, a part of any diversified portfolio. And certainly, in terms of generating income, the Barclays Aggregate will continue to do that.
Stephen Dover: I think what maybe is interesting, at least to me from the equity point of view, is all investments, including equity, are really a discount of future income streams. Maybe what a lot of investors don’t know is if you look over the past 40 years, 40% of the S&P 500 return actually came from dividends. And even looking at this last decade, 17% of return came from dividends. So, income is important in the equity markets as well. So, the other question we get is a lot of investors are trying to figure out what to do with cash. What is your thought now about people in cash, or how they should look at that from a fixed income perspective?
Doug Hulsey: You know, cash is yielding close to zero now. Certainly, if you needed to make some immediate payments for a purpose, you need some investments parked in cash, but when you think about the economic construct and certainly the supportive comments from the Fed, that is great news for the fixed income markets. And certainly, you want to think about, as investors, considering going out the [yield] curve, if you will, considering spread product to add incremental yield in your portfolio. And, you’ve got to think about your longer-term return objectives.
Stephen Dover: Thank you very much, Doug, for being here.
Doug Hulsey: Thank you.
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1. A basis point is a unit of measurement. One basis point is equal to 0.01%.
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3. Duration represents the sensitivity of the price of a bond or other debt instrument to a change in interest rates, and is expressed in years.