Bonds 202: Risk and Upside When Rates Are Low

Bonds 202: Risk and Upside When Rates Are Low

In a prior Adviser Fund Update, we explored the role bonds can play in your portfolio, showing how they can provide steady income and portfolio stability even in down markets.

Since then, the world has gotten a little more unsteady. COVID-19 has swept the globe; millions of people have had their lives turned upside down by job losses, business closures and orders to shelter in place; the stock market plunged and then rallied. And in recent weeks, bond yields started to creep up after falling to record lows in 2020. So, it seems like a fine time to talk about how much risk you should be willing to take on when it comes to bonds, the steady-Eddie, conservative part of most investors’ portfolios.

A Refresher On Risk

As we’ve touched on before, many business and government entities issue bonds, but they are not all equally sound borrowers. In general, the more likely a borrower is to pay back investors, the easier and cheaper it is for them to raise money, and the lower the interest rate (coupon) of their bonds. The higher the risk of non-payment (default), the higher the interest rate the issuer must offer to attract investors, and the higher the yield on the securities.

Bonds issued by governments (which have the power to raise and collect taxes to pay bondholders) tend to be regarded as “safer” than those issued by corporations. U.S. Treasury bonds, issued by the richest and most powerful country in the world, are regarded as safest of all—and historically have tended to have the lowest yields. (In recent years, some bonds from governments in Europe and Japan have been issued with negative yields, a phenomenon once considered impossible. In these cases, some investors have proven willing to pay for the privilege of keeping their money safe.)

Exactly how safe a particular bond may be is a question that ratings agencies attempt to answer. Three firms—Moody’s, Standard & Poor’s and Fitch—are the official arbiters, assessing the creditworthiness of issuers and grading each bond offering based on their judgement about how likely the issuer is to pay investors back.

While each firm maintains its own proprietary grading system, and they may differ slightly in their assessments of a borrower, their ratings matter. Many large institutional investors like pension funds and endowments opt to invest only in bonds that have been given a high grade by the ratings companies. Bonds rated highly enough are termed investment-grade. (Adviser Investment’s own Managed Bond Program only invests in investment-grade bonds; click here to read more about how we select bonds.)

What about all the companies that issue debt, but whose shorter track records or shakier balance sheets don’t quite merit a high grade from the ratings agencies? Well, back in the 1980s, when even super-safe securities like the 30-year-Treasury note were offering rates in excess of 10%, below-investment-grade issues were known as junk bonds. Nowadays, with 30-year Treasury yields touching just 2.22%, such instruments have acquired a different nickname: High-yield bonds.

High-Yield and You

Why are high-yield corporate bonds in demand in the current market?

In part, we have the Federal Reserve to thank for that. To combat the pandemic’s impact on the U.S. economy, the Federal Open Market Committee (FOMC) set its benchmark federal funds rate to near-zero in March 2020, just as it did in 2008 to help counter the Great Recession. The Fed has since indicated it plans to keep rates low until employment returns in full, or, in other words, for the foreseeable future. (Following the 2008 financial crisis, the Fed didn’t raise rates again for seven years, helping to keep Treasury interest yields below the rate of inflation for much of the decade.)

The rule of thumb is that when government bond rates are low, an allocation to high-yield bonds becomes more appealing for investors who can tolerate their higher risk.

It’s important to remember that there’s really only one piece of bad news that matters when it comes to bonds: the issuer isn’t paying you back. While it’s likely that some troubled businesses will default on their bonds in the wake of the pandemic, a well-managed, diversified bond fund invests in an array of different issuers precisely to mitigate that risk.

Generally, if the economy recovers swiftly, rates are likely to continue to rise, helping your high-yield bond returns.

In sum, there are some times when investors get compensated for taking the risk that’s associated with junk bonds and other times when they don’t. Unless we somehow enter an economic depression in the foreseeable future, now may be a time when the opportunities outweigh the risks.

Fidelity’s Index-Fund Manager Shutters Hedge-Fund Business

Geode Capital Management, the co-manager of Fidelity’s stock index funds, has closed its hedge fund strategies and dissolved that segment of its business following massive losses.

Geode’s role as Fidelity’s index fund manager accounts for the majority of its $720 billion in assets. Its riskier, hedge-fund strategies were offered only to wealthy clients and institutions.

As first reported in the Wall Street Journal, Geode’s largest private fund lost about $250 million last year when derivatives trades went south during the pandemic-induced bout of market volatility. The fund was down by as much as 36% last spring, prompting Fidelity to pull out of the fund.

Geode began in part as a family office for the Johnson family, but was spun out from Fidelity nearly two decades ago. It is currently owned by a consortium of its employees, including former Fidelity executives and a Johnson family trust.

In its role as index-fund subadvisor, the firm is charged with making the necessary trades to keep Fidelity’s stock index funds in line with their benchmarks.

It has long offered a suite of non-index funds. The Geode Diversified Fund, which launched in 2003, pursued a number of different strategies and held a variety of assets, including stocks, convertible bonds, currencies and commodities. In 2018, the fund held approximately $1 billion in assets.

Despite the losses in the Diversified Fund, overall the firm benefited from the market rally that boosted stocks in the second half of 2020, with its total assets up by more than $135 billion.

Podcast: A Tactical Take on High-Yield

Generating steady income while successfully managing risk is what every bond investor aims for—and we think a tactical investing approach can help get you there. Director of Research Jeff DeMaso and Quantitative Investments Manager Josh Jurbala are back for the second part of our multi-episode look at tactical investments, this time diving deep into the investing philosophy behind our AIQ Tactical High Income strategy.

In this insightful conversation, Jeff and Josh discuss:

• Why high-yield bonds can be safer than you think
• The role high-yields can play in a portfolio
• Why a tactical approach can be especially useful when it comes to high-yield assets
• … and much more

Tactical investing is a disciplined, rules-based approach that can help eliminate the emotional biases all investors are prone to. It’s not for everyone, but is tactical for you? Click here to listen now!

(You can also tune into part 1, “Making Tactical Practical: An Introduction to Tactical Investing,” by clicking here.)

Adviser Investments’ Today’s Market Takeaways

There’s no shortage of hyperbolic headlines and provocative punditry in the financial media. But you won’t find such hysterics here. In Today’s Market Takeaways, members of our investment team provide timely videos that clearly and concisely explain what we’re seeing in the markets.

Research Analyst Liz Laprade talked about the difference between inflation and hyperinflation. And Vice President Steve Johnson discussed what rising interest rates mean for investors and the economy.

We hope you find these episodes engaging and accessible, and please let us know if there are any topics you’d like to hear us address by sending an email to info@adviserinvestments.com!

About Adviser Investments

Adviser Investments is a full service wealth management firm, offering investment management, financial and tax planning, managed individual bond portfolios, and 401(k) advisory services. We’ve been helping individuals, trusts, institutions and foundations since 1994, and have more than 3,500 clients across the country and over $6 billion in assets under management. Our portfolios encompass actively managed funds, ETFs, socially responsible investments and tactical asset allocation strategies, with particular expertise in Fidelity and Vanguard mutual funds. We take pride in being The Adviser You Can Talk To.

Our minimum account size is $350,000.  To see a full list of our awards and recognitions, click here, and for more information, please visit www.adviserinvestments.com or call 800-492-6868.