Much has been made about the heightened correlation between bonds and equities. Indeed, correlations have spiked rather significantly between multi-sector fixed income funds and equity proxies such as the S&P 500® Index. But in our view, there is more than one way to frame the issue. For instance, we believe advisors should keep in mind that bonds have essentially come full circle and are now playing their traditional roles. That is to say, they’re not providing equity-like returns — they are simply delivering income. And we believe that spread sectors, especially corporates, are good places to sit and clip coupons for now.
We believe there are good reasons not to run from bonds that have delivered equity-like gains in recent years. Consider high yield bonds, for instance. To borrow a baseball analogy, high yield bonds are in the ninth inning when it comes to price appreciation, but they are still in the fifth inning when it comes to the credit cycle. What I mean by this is that we’re still seeing companies refinancing and strengthening their balance sheets, and we see no evidence of the activity usually manifested in later innings (such as a wave of transactions that are highly leveraged, which usually begins setting the stage for the next downturn). High yield defaults are running at a low rate of 1.5 percent, and we believe we are not going to see any significant credit incidents in the coming quarters.
On the other side of the coin, however, we feel investors need to see that prices have been pushed as far as they can go. If there is some sort of macroeconomic shock — the unemployment situation worsens, for instance — there could be some price loss, but as of now, bond prices appear to be quite full. Even the often-debated threat of inflation seems rather benign to us. There simply isn’t enough price pressure at the moment, particularly when you consider how much resource slack remains in the economy here at home (and that global GDP growth is generally slowing).
A Word About Interest Rates
As bond investors who have expertise in U.S. credit, we are not averse to a scenario in which interest rates are rising, so long as the economy ticks upward as well, which is the situation we find ourselves in now. This combination could signal an environment in which corporations can once again work on their top-line growth, which would be attractive to us. Why this focus on corporate America? Because it’s our view that over the long term, you earn more income by clipping a higher coupon in spread sectors like high yield, than you would by sticking too close to Treasurys.
The Pace Of The Game Has Slowed
Our belief is that a sensible approach to bond investing should entail a mindset of collecting nickels around the world, because there just aren’t many big areas of price gains left. In high yield, for instance, an area where credit is currently strong (with exceedingly low default rates, as noted above), the math tells us that further price appreciation appears unlikely.
Regardless Of Market Conditions, Emphasize Risk Management
At Delaware Investments, a core component of our approach is that we tend to be downside conscious, and we believe that capital preservation is among the most important parts of our investment mandate. Our risk awareness means that we seek to outperform during down markets, even if it means an increased likelihood of underperformance during bull markets. In short, we believe it makes sense for fixed income investors to protect on the downside, aiming for less volatility along the way.
A Closer Look At Spread Sectors Amid Rising Rates
Looking back at periods of rising rates during the past 25 years (defined as moves of at least 75 basis points in 10-year Treasury yields), 16 total periods turn up. Several observations are worth noting, particularly from our viewpoint as spread investors:
• Total returns for high yield bond mutual funds were negative in only two periods.
• Total returns for bank loan funds did not decline in any single period.
• 10-year Treasury bonds experienced negative returns in all periods.
Data: Morningstar Direct; Bloomberg. As of June 6, 2013.
Paul Matlack is senior vice president, senior portfolio manager and fixed income strategist for Delaware Investments. His firm oversees $145 billion in fixed-income strategies.