With VettaFi’s Fixed Income Symposium happening on Monday July 24, Evan Harp sat down with Robert Michaud of New Frontier Advisors to get his take on the current state of fixed income.
Evan Harp: Obviously, fixed income is top of mind right now. What is something that most investors aren’t thinking about in regards to fixed income?
Robert Michaud: In a very literal sense, I think they’re not thinking about the math behind the yield curve, and what bond math means.
So, a yield curve this deeply inverted mathematically implies rates would need to fall sharply and quickly to have short-term, let’s say two- or three-year bonds, outperform simply rolling over something like Treasury floating-rate notes, my favorite current fixed income asset. Because they’re zero-duration, they’re the least risky fixed income out there. And you’re just not getting paid for taking risk in fixed income — maybe some credit risk. But we’ve been really struggling with duration, and it doesn’t seem like you’re getting paid to take risk with duration, except for possibly at very long maturities.
To get back to directly and literally answering this question, I think the thing people are missing is that they are not looking at the math and the risk and return trade-off of owning riskless zero-duration Treasuries versus something two or three years out. Given that the Fed has said that it is raising interest rates for a little while longer, and then eventually lowering them, this is probably not giving investors the outcome that they’re expecting.
To add some nuance for relatively short-duration securities, there’s not a whole lot of benefit. There’s a little bit of price volatility, obviously not too much price volatility in a two- or three-year Treasury, but there’s some. So, while there’s limited downside, there is not too much upside.
Whereas if you think about a much longer Treasury, maybe a 20-year, then those have historically been something that people would invest in for a multitude of reasons. There could be a duration premium. So, by holding longer-duration securities, over time, you will get rewarded for that in terms of a higher yield on average, than having short-duration securities.
Another would be meeting a liability. So, for an insurance company or pension plan that knows it has to pay out 20 years from now, it’s a way to “risklessly” meet those obligations.
The third reason is a hedge. And this is something that we’ve heard about before. A long-duration investment can protect you in case of a downturn in the economy. And it seems like, again, the mismatch is that there are some investors out there that like the hedge but are scared because of what happened in 2022 and not willing to have very long-duration securities, which actually could provide a meaningful hedge to equities in the event of a more-severe-than-expected recession.
To summarize, they’re mismatching both the return and risk trade-off for short fixed income, and they’re not really thinking fully about how it would work with longer-duration fixed income.
What to Expect for the Rest of 2023
Evan Harp: Looking ahead to the next two quarters, the final two quarters of the year, what are some of the challenges fixed income investors are facing? How is New Frontier advisors navigating those challenges?
Robert Michaud: Similar to what investors are missing right now, I think that this highly inverted yield curve is providing a bit of a disconnect from what standard investors are used to, which is having slightly longer-duration investments inside their portfolio and being able to expect a higher rate of return from that exposure.
What we do is look at the risk and return trade-off of all potentially investable assets, and think about how each fits best in a portfolio. Given that there’s no compelling evidence that you’re being significantly rewarded for taking a moderate amount of duration risk in a portfolio, we’ve chosen to take advantage of the high rate of return from the short end of the yield curve and take risk in other parts of our portfolio.
The 60/40 Portfolio
Evan Harp: Let’s talk about the 60/40 portfolio. Is it back? Why or why not?
Robert Michaud: I don’t think the 60/40 portfolio was ever really gone. When I think of the 60/40 portfolio, I think of the 60/40 portfolio as what most investors should use as their default investment choice. If you add up all investments globally, you end up with something that’s pretty close to 60% stocks, and 40%-ish bonds. Since this is literally the average of all investable securities, this also means that this is the starting point for an average investor.
You should never have all investors in just one thing. So that brings up the question, “What should a 60/40 portfolio — or a balanced portfolio that’s thinking across all asset classes for a moderate risk investor — be invested in?”
The 60/40 portfolio had a rough time in 2022. I think that has led a lot of people to be skeptical of this old model for 60/40, where you just had lots of duration and a very standard equity solution, and expected it to perform well. We continue to be in an environment, I think, where that naïve 60/40 portfolio is not going to perform particularly well, though certainly better than 2022. But the right 60/40 could do well — equity prices are priced more to account for some of the economic slowdown, and so there’s a higher future return premium on equities, and bond yields are just much higher, which means that also bond returns should be better going forward.
I think it’s more important than ever to think about properly optimizing your portfolio and taking advantage of the shorter yield curve, especially in a portfolio where you’re trying to balance risks. You save a lot of risk by optimizing away a lot of duration risk and investing more in various equities and bonds with a premium for taking risk. So, it’s actually a pretty good time for the 60/40 portfolio.
Michaud on the Rise of Actively Managed Fixed Income
Evan Harp: That’s an excellent answer. I have one last question here, and that’s on actively managed fixed income ETFs. They are on the rise. What do you see as the opportunities and challenges for these products?
Robert Michaud: There are two things going on. One is the shift towards ETFs, and the other is the role of active management in a portfolio.
From a theoretical and practical perspective, active management has always been here and will always be here. It’s necessary to keep markets efficiently priced, and so active managers do a very valued service to all investors in that sense. And ETFs are just a better investment structure for most investors. Active management is realizing this. New regulations have made it possible for this to happen. It’s very sensible that there has been a continued shift towards actively managed ETFs, which means away from actively managed mutual funds.
The other thing going on with active ETFs is thinking about how they function inside a portfolio. There are two reasons why you might want to invest in an actively managed fund. One is that you think that an active manager has true skill and can provide more return than investing in a passive fund. History hasn’t borne that out well. There are good mathematical reasons why, on average, investors should not win from picking an active manager. For most investors, it’s just not worth the time to try to figure out whether there truly is an extra return expectation from an actively managed fund or not.
The other thing that may be more reliable is that there are active portfolio managers who have a great deal of skill and information about the markets that they’re investing in and are able to more rapidly and more accurately manage the risk of their portfolio. This could be highly valuable for an investor who does not have the time or the skill to be able to do that themselves. It’s worth thinking about how that could benefit your whole portfolio.
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