In The New Era, Fixed Income Retains Its Role As A Diversifier

As the shift to alpha-driven returns unfolds, investors may be tempted to question the continued validity of bonds as diversifiers. Some research shows that negative stock-bond correlations, which are suggestive of strong diversification benefits, are associated with accommodative monetary policy.

Our answer, unequivocally, is that bonds will continue to play a vital role in portfolio diversification—both in the new era and throughout changing market cycles for many years to come. In our view, though, skilled active management will be crucial to producing positive returns and creating those diversification benefits.

Challenge: There is little yield cushion

We believe it will be possible to earn competitive returns from fixed income, but it will require greater skill than in years past. One of the biggest challenges will be to manage interest-rate risk when there is virtually no yield cushion to buffer the effects of rising rates.

A comparison here is useful. In the pre-crisis period, when interest rates were higher—and even going back as far as the 1980s—a generic allocation to investment grade fixed income provided both return and diversification properties because bond yields were much higher. In the 1990s, for example, an investor could buy A-rated corporate bonds with yields averaging over 7 percent. Such bonds could absorb an approximately 130-basis point rise in U.S. Treasury yields before incurring an absolute return loss. That sort of yield cushion does not exist today. In fact, a rise of just over 50 basis points in U.S. Treasury yields could trigger an absolute return loss in today’s market, all else being equal (Display 2).

We are not suggesting that yields are going to spike higher anytime soon, but we are suggesting that we are near an inflection point. As we see it, the secular decline in yields is coming to an end, and bond yields may bounce along the bottom and trend higher in the years to come (Display 3).

Shift Toward Alpha Requires Change In Strategy