All fixed income is not created equal
Maintaining a classic 60/40 investment split is easy; choosing the right bond mix may be a little harder
Investors have long considered bonds to be an important component of their portfolios. Now, more than ever, with conventional bonds offering record low yields over longer time horizons in the face of newly-awakened interest rate and inflation risk, they’re coming to terms with the fact that not all bonds are created equal.
Bonds come in many different flavours, some of them subtle. Government bonds break down into five different sub-types: federal, provincial, municipal, agency and treasury. Corporate bonds break down into two: investment grade and high yield.
Lending to a corporation, investors expect higher rates of return because the credit risk is higher. To a lesser extent, corporate bonds also carry a degree of interest rate risk because a component of their yield is leveraged to changes in the yield of government bonds. The “credit spread” inherent in corporate bonds measures the additional expected yield beyond that of government bonds.
“If an investor in the 1990s wanted a five per cent annual return on their fixed income, they could invest in Government of Canada bonds and let it ride,” says Marthinsen. “We’re in a paradigm shift for investors who once turned easily to the safety of government bonds for predictable yield. Today, yields on government bonds are so skinny that investors are turning elsewhere to find yield in different places.”
Many investors are choosing corporate bonds to increase rate of return in their fixed-income investments. Corporate bonds can provide those returns both through higher initial yield and through spread compression — if the market determines that the credit worthiness of a company has improved, its yields will fall, driving the price of those bonds higher.
Marthinsen notes that a snapshot of the first calendar quarter of 2021 offered significant indication of this paradigm shift in the bond market, when interest rates spiked dramatically. At the same time, the FTSE Canada Universe Bond Index — a portfolio of investment-grade corporate and government bonds — registered a drop of five per cent on a total return basis.
“This is considered a ‘safe’ bond portfolio,” he says. “And yet that drop in total returns was attributable to a single spike in interest rates. The last time we saw a loss of that magnitude in the universe bond index during a single quarter was in the early 1990s. Could this happen again? Definitely.”
The possibility of a repeat is heightened when an increasing number of corporate bond issuers looking at low rates are seeking to lock them in for longer durations. When duration in the index is higher, the universe basket of bonds becomes more sensitive to interest rate risk. At the same time, coupons are lower, removing the buffer that investors may have once counted on.
“Our contention is that a seasoned active manager who knows how to allocate among corporate bonds can adequately account for total bond risk” says Marthinsen. “That can help manage ongoing overall volatility and provide good risk-adjusted returns.”
An active manager can make a determination of absolute bond risk calculating, for example, that a shorter-term corporate bond with slightly higher credit risk but better yield can provide a better overall risk profile than a 10-year government bond offering yields scraping bottom.
Lysander’s contention, therefore, is that news of the death of the 60/40 portfolio has been greatly exaggerated.
“Is it a bad time to own bonds?” Marthinsen asks? “Not at all. But in an investment environment demonstrating a paradigm shift regarding absolute bond risk, you might want to rethink your conventional bond strategy and become more tactical in how they’re deployed.”
®Lysander Funds is a registered trademark of Lysander Funds Limited.