On the recent webcast (available On Demand for CE Credit), Investing Beyond the Bond Benchmark, Edward Kerschner, Chief Portfolio Strategist for Columbia Threadneedle Investments, warned of potential risks in the current low-rate environment that many fixed-income investors will have to overcome.
Yields on 10-year bonds have declined from a 15% high in 1982 to under 2% in 2013 and are now hovering a little over 2%. Driving the recent pressure on yields, most of the developed world tried to reignite growth following the 2008 financial downturn, with central banks implementing low and even zero interest rates plus quantitative easing. The policies of the past four decades has pushed down bond yields and extended the prolonged bull market in debt securities.
If rates remain stubbornly low, the government may rely on fiscal stimulus to augment growth, which could further strain a budget deficit and drive inflation and rates higher. Consequently, investors’ reliance on a traditional cap-weighted bond benchmark like the Bloomberg Barclays U.S. Aggregate Bond Index, may do more harm than good.
The Bloomberg Barclays U.S. Aggregate Bond Index is comprised of 9,397 debt securities worth almost $20 trillion in assets. The so-called Agg now has an overweight 37% tilt toward U.S. Treasuries, compared to a 22% position in Treasuries back in 2007. Furthermore, when factoring debt issued by government agencies’ and mortgage-backed securities, the total government exposure is now over 70%.
“The benchmark index weightings do not foster diversification, with correlations among the components high; positioning investors in the low return/low volatility segment of the market,” Kerschner said.
Alternatively, investors may look to multi-sector bond strategies that pick and choose opportunities as opposed to being restricted to a traditional market capitalization weighting methodology.
“Such a strategy could address the investment universe screened by yield, quality and liquidity,” Kerschner said. “Investors seeking higher returns could be well-served to move out along the risk-reward profile.”
For example, Kerschner pointed to other sectors that are not traditional found in the Agg, such as high-yield, global Treasuries or emerging marekt debt, which exhibit lower cross-correlations that help diversify a portfolio and potentially enhance yield generation.
“Moving out along that risk-reward profile finds opportunities that are both less correlated and have historically offer relatively high returns,” Kerschner said.
As we move out of the comfort zone of low-yielding but safer U.S. government, investors will be exposed to potentially greater risk in higher yielding debt. Nevertheless, Gene Tannuzzo, Senior Portfolio Manager of Strategic Income for Columbia Threadneedle Investments, pointed out that a smart beta or alternative index-based ETF strategy, like Columbia Diversified Fixed Income Allocation ETF (NYSEArca: DIAL), can manage yield, quality and liquidity through a transparent rules-based process.
A rules-based or smart beta ETF can screen for specific factors to find the right balance between yield, quality and liquidity. For example, yield enhance can exclude short-term government debt with limited yield, non-government with limited risk premium and negative yielding bonds. The quality screen would exclude those corporate debt rated below single B, rated below double-B and longer than 15 year maturity that have greater downside risk. Lastly, a liquidity screen that looks for larger issue size, recently issued securities and a limit on bonds per issuer can help provide investors with greater liquidity to manage against volatility.
DIAL’s underlying index tries to target six sectors, including U.S. Treasury securities (10%); global ex-U.S. treasury securities (10%); U.S. agency mortgage-backed securities (15%); U.S. corporate investment grade bonds (15%); U.S. corporate high yield bonds (30%); and emerging markets sovereign and quasi-sovereign debt (20%). Each sector is market value-weighted except for the global ex-U.S. Treasury Securities, which is equally weighted.
“A market cap-weighted international treasury index, such as the World Government Bond Index, has a disproportionate exposure in a small number of countries, notably a concentration in Japan. The result is an index that has a high concentration, low yield and long duration. The Beta Advantage Multi-Sector Bond Index methodology provides a more diversified country and currency exposure, investing in higher yielding countries, and a modestly shorter duration,” Tannuzzo said.
Financial advisors who are interested in learning more about alternative fixed-income strategies can watch the webcast here on demand.