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Text on screen: Josh Davis, Global Head of Client Analytics
Davis: I think this is certainly a very interesting time for many investors. I mean we haven't seen bond yields this low pretty much in modern history. That said, we've certainly seen it in the case of Japan Germany, which we'll discuss in a moment.
But what we wanted to do is take a deep dive into this whole topic of the role of fixed income and try to really ascertain the relevance of fixed income in portfolios going forward.
Text on screen: 1. Fixed income: a time-tested diversifier to equities
I think the most important reason why investors allocate to fixed income is because of the fact that they seem to offer ballast in a portfolio.
That is to say that they offer very different risks than what's embedded in equities, and equities are clearly the most dominant risk in portfolios. Fixed income traditionally, at least over the last 20 or so years, has delivered a very negative correlation with that of equities.
Full page graphic: Line chart titled, “Stock-bond correlation in the U.S.” plots the up and down correlation between stocks and bonds in the U.S. since 1933. The line declines (less correlation) more over the last 20 years versus the prior periods since 1933.
When we actually take a look at fixed income historically, we think this is actually a very critical factor. The defensive nature of fixed income in portfolios is incredibly important.
It isn't only reliant on the stock-bond correlation being negative on average. In fact if we look at nine out of the last ten recessions, many of those recessions corresponding to periods where the stock-bond correlation was actually positive, bonds consistently delivered positive performance.
So we think that defensive nature in fixed income is extremely important, and certainly with yields today at around 1.5% on the U.S. 10-year, they're much more defensive than they were at 50 basis points. The further you are from the zero lower bound, certainly the more that fixed income will display these defensive characteristics.
But of course that's not the only story. It goes much deeper than that.
Full page graphic: The text chart titled, “Fundamentals of fixed income” compares macro fundamentals (demographics, productivity, inequality, preferences, inflation, monetary policy, bond market net supply), their trends and impact, and their net impact on rates. All have a lower impact on rates except inflation, which is higher.
As we move on to the fundamentals in fixed income and we take a look at what's driving real bond yields, it's many of these macro trends that we don't think will change any time soon. Things like demographics—as agents age in the economy they certainly need to save more—creates a bid for fixed income.
Other factors, like the COVID scenario, which change preferences of many agents, that results in a bid for fixed income as many try to actually build up their savings and rainy-day fund to combat these sorts of severe scenarios.
When we actually take a look at valuations that's also quite interesting. Many would think that naturally equities would be the pivot in a portfolio to pursue, as bond yields offer less in terms of return, but that, of course, isn't the whole story.
When we look at valuation models it actually says something very interesting. First and foremost, the relative value of equities to bonds—so when we look at the earnings yield on equities and we compare that to the real bond yield—that is actually in a very sort of suppressed state. We'd expect, therefore, bonds to be quite cheap relative to equities, kind of in opposite to what many think.
Text on screen: 2. Yields alone don’t necessarily reflect total return
I want to talk a little bit more about bond yields, because bond yields don't tell the whole story. In particular, when yields are low there's this kind of interesting thing that's happened in places like Japan and Germany.
Full page graphic: The bar chart titled, “Annual returns of 10-year JGBs and 12-month Libor” compares the annual rate of return for the 12-month Libor versus the 10-year JGB since 1999. Since 1999, the 10-year JGB has had high returns at the start of the series to more modest returns moving negative in 2003 ands also during the past 2 years. The 12-month Libor has seen more modest returns with slight increases over the course of the period, always staying positive.
So what we did is we took a look at Japan going back to around 1998 when bond yields have been sub-2% ever since, and tried to kind of decompose and understand why the returns have been so high.
They've been far in excess of cash, and in fact the bond returns in Japan, looking at, for example, the 10-year Japanese government bond, has delivered somewhere on the order of 3x the Sharpe ratio of equities. There I'm kind of referencing the NIKKEI Index as the relative equity investment.
When we take a look at Germany we see the same sort of thing unfold. German bunds—so the 10-year German bond—has been sub-1% yield since around 2014, and there that bund sort of return has delivered around 3x the Sharpe ratio of what we've seen in German equities, as evidenced by the DAX.
So there's this question of why the Sharpe ratio has been so high. Part of that, of course, is due to the denominator effect, the fact that risk has been lower. As yields drop, volatility has dropped as well. But that's not the whole story, as much of it is packed in the numerator, the fact that there has been an excess return above cash that's been significant.
So when you actually try to understand what's going on, you see that bond yields don't tell the whole story. Actually, the term premium tells you a lot around the excess return in bonds. So the steepness of the curve matters.
Just to kind of think of it, if you buy a ten-year bond and you hold it for one year and sell it as a nine-year bond and reinvest in a ten-year, not only are you getting the yield on that bond for that one-year holding period, but you're also getting the fact that you're rolling down the curve, and the term structure may be steep.
And so that explains a lot about the excess return on Japanese government bonds and German bunds. And interestingly enough today, if we take a look at the steepness of the U.S. yield curve, it's quite steep. So the difference between the two- and the ten-year yield is on the order of 120 basis points.
And when you look at that compared to what was realized historically in Japan, the average curve steepness in Japan was only about 90 basis points.
Text on screen: 3. Fixed income alpha has offered consistency
Full page graphic: The bar chart titled, “10-year active versus passive fund performance” compares Morningstar categories with the probability of outperformance over median passive peers and the 10-year average returns. High yield bond category has the highest probaiblity of outperformance over median passive peer (76%), followed by intermediate core bond (66%), short-term bond (44%), large growth (15%), large blend (8%) and large value (24%).
Active management, or the delivery of alpha, in bond portfolios seems to be quite consistent and substantial. We took a look at the Morningstar database and analyzed all bond managers in that database, as well as equity managers, and found that story to really play out.
Equities, for whatever reason, active management has not really been rewarded over the past 10 to 20 years, whereas in bonds it's been consistently sort of rewarded. Insofar as alpha is incredibly important, as beta returns have been somewhat constrained going forward, active management would seem to offer a key opportunity.
Finally, we want to mention that inflation is the fly in the ointment here. We haven't discussed inflation much, and should we go through a big inflationary episode that would certainly be negative for bonds. So we'd certainly point the interested sort of client in that direction as something to investigate.
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