Quality Bonds: an Underappreciated Role in Portfolios

Stock markets across the globe fell sharply during the first few weeks of 2016. After years of strong stock market performance, downturns like these remind investors of the importance of diversification and disciplined portfolio construction. Even though interest rates remain near historic lows, bonds remain an important part of this diversification as adding them to portfolios lowers volatility (i.e. risk). Historically, high quality bonds, that is those with lesser credit risk, proved an important source of diversification during periods of equity market stress, offering lower correlation while their lower quality brethren tend to have returns more highly correlated to stock market returns. Lower quality bonds imply greater credit risk, which is the risk of not getting paid because the issuer goes bankrupt.
Whenever the outlook for the stock market is threatened, investors will sell risky assets to buy safe investments. This ‘flight to quality’ behavior is a well-known herding reaction to bad news. Historically, owning high quality bonds provides a diversification boost during periods when portfolios need it most. At Crestwood, we include high quality bonds in portfolios to provide a ballast against equity risk which helps to offset periods of stock market stress.

Despite these attractive qualities, concerns over lower expected returns and potential interest rate increases have reduced the appeal for quality bonds. Unfortunately, the near historically low current yields for bonds is suggestive of low future returns (see Perspectives 5/1/15). In addition, the Federal Reserve is on a path to reduce their aggressively stimulative policy of near-zero interest rates. In December 2015, they increased the federal funds rate for the first time since 2006. When interest rates rise, bond prices fall, because most bonds have fixed interest payments and higher rates make these fixed interest payments less valuable. So, not only are lower returns expected, but depending on the pace of future increases in interest rates, it is possible that returns for some bonds could be negative.

This environment has left investors searching for yield in lower quality areas of the bond market. One of the more recent choices in the marketplace has been “unconstrained” bond funds, which raised a significant amount of assets over the past few years by generally offering above-average yields and the promise of deftly navigating the shifting bond market. On the surface these “go anywhere” bond funds look appealing, but they generally boost returns by taking on greater credit risk and sometimes using leverage. As a result most of these funds have similar credit profiles to high yield bond funds and have proved to be poor portfolio diversifiers in times of market stress.

The problem with credit risk in bonds is that it is very similar to equity risk. When investors are concerned about economic growth and earnings, stocks tend to fall in price. During these periods investors will also sell high yield bonds because weak growth can lead to higher defaults. In 2008 stock indices were down 37% to 53%, but what is less remembered is that investors in high yield bonds, emerging market bonds and floating rate notes also faced losses (See below chart). During this period of weak stock prices only high quality bonds rose in value, conversely bonds with credit risk sold off and did not provide protection to the portfolio when it was needed most.

Perspectives1Increases in the federal funds rate does not necessarily cause all interest rates to rise. Given the lackluster economic growth of the U.S., the rate increases may affect yields on bonds of shorter maturities rather than bonds of all maturities. Investor concerns of the potential for high inflation and rising long-term rates have not materialized and appear to be exaggerated.

In addition to understanding the effects of different market scenarios, it is important to look at portfolio risk holistically. Our analysis shows that for the majority of investors the biggest source of risk in a balanced portfolio (up to 90%) is equity risk. Given that the majority of risk in a diversified portfolio is equity risk, it’s clear that the addition of high quality bonds is a better diversifier than adding lower quality bonds with more credit risk that will behave like equity risk.

For taxable investors, stocks are a better way to take on equity/credit risk than high yield bonds. This is not only because equities offer greater long term return opportunity but also because of the different tax rates on the sources of those returns. Most of the returns from stocks come in the form of capital gains, which not only can be deferred, but are also taxed at a lower rate than income from dividends or interest. Historically with high yield bonds, the majority of return is from the taxable coupon payment, which for investors in the highest tax brackets means that as much as 50% of the high yield return taxed away. This is why on an after-tax basis, high yield returns rarely outperform municipal bonds for taxable investors.

At Crestwood, we build portfolios with an eye on holistic portfolio risk and the goal of maximizing favorable outcomes in a variety of different market scenarios. We believe that high quality bonds are an important part of a diversified portfolio as they will behave differently than the rest of the portfolio during periods of stock market weakness. We build diversified portfolios in a thoughtful manner to achieve consistent returns and reduce portfolio volatility as best we can. Finally, we are mindful of the effect taxes can have on returns both from stocks and bonds when considering asset allocation.

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