To the surprise of many, interest rates—already low for most of the decade—have continued their slide across 2019. Due in no small part to current events like a potential economic recession and a trade war with China, rates on safe-money, 10-year U.S. Treasuries have dropped from 3.24% in November 2018 to as low as 1.45% this September.
These falling rates have been good for passive bond strategies. From here, however, it is reasonable to expect the fixed income market to be a bit more challenging. We believe portfolios will need an active component if they are to deliver satisfactory returns to their investors.
It’s Been Great To Be Passive
Everything can change in a matter of weeks. Owning the benchmark is usually fine in a rally, but what happens when things change? If rates do move higher, bond returns may move lower perhaps than they have in years.
The rally in rates has been stunning to watch. The Bloomberg Barclays U.S. Aggregate Bond Index is up 8.52% through September, while an index of U.S. corporate bonds is up over 13%.
While benchmark-driven bond funds have performed well, higher rates will by definition produce challenges for long-only, benchmark-driven bond portfolios. This will cause new money in long-only bond portfolios to lose money over the short to intermediate term as there is not enough yield in today’s market to make up for a meaningful price change.
What can bond investors do in such an environment? We suggest they look to investment strategies and portfolio managers that pursue pockets of potential alpha which passive strategies typically ignore. The differentiated return is called active share.
But It’s About Time To Get Active
Owning the benchmark might be fine, at least for a while. In fact, the markets may rally even further from here. But when a risk/reward trade-off becomes skewed against a long-only, buy-and-hold bond strategy, investors may seek out non-benchmark-like sources of return to bolster returns in their fixed income portfolios. The good news is that there are plenty of ways to add differentiated returns in today’s market.
Unlike benchmark-driven approaches, Shelton Capital Management believes an active strategy provides an opportunity to “lean in” to change. Nothing creates change like the volatility that comes with major market moves such as rising rates. In that environment, there will almost certainly be changes in absolute and relative pricing of at-risk assets along with variations in value between different sectors of the credit market, and swings in the yield curve. And there can always be changes, both good and bad, in the industries that make up the corporate space.