Lazard Insights
Rethinking Fixed Income Allocations Joe Ramos, Managing Director, Portfolio Manager/Analyst
Summary • Interest rates are at levels not experienced since the Great Depression, even though the current economic environment is dramatically stronger today than it was in the 1930s. • Under current underlying economic conditions, an extension of the US Federal Reserve’s zero-rate policy is likely to lead to asset-price bubbles or inflation. • Many investors believe the Fed is in control and the fixed income market is liquid, however, after its extended expansionary programs, the Fed is out of accommodative policy tools and new regulation has impaired dealer market making, thus adversely affecting fixed income liquidity. • While a US fixed income allocation remains an essential building block for asset allocators because of its defensive and diversifying characteristics, it is crucial to consider the exact composition of the allocation within the context of the unique conditions governing the current market landscape.
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The Current Low-Rate Environment US fixed income markets are at an inflection point. The current low interest-rate environment is inconsistent with underlying economic conditions. Although interest rates are at levels not experienced since the Great Depression, economic conditions today are radically different. In the United States between 1930 and 1938, nominal GDP declined by 16.9% (-2.0% annualized), while CPI declined 18.6% (-2.3% annualized), and, by the end of 1938, unemployment still stood at 19%, with no safety net in place, such as social security and unemployment benefits. In contrast to those dire circumstances, from 2008 to 2014, nominal GDP has increased by 21.9% (3.5% annualized), CPI has increased 10.5% (1.7% annualized), and more importantly the current unemployment rate has recently fallen to 5.8%. Currently, initial jobless claims remain below 300,000 and non-farm payrolls have consistently been above 200,000 per month (for the greater part of 2014) while consumer and CEO confidence are back to pre-crisis levels.1 This current economic environment in the United States is sufficiently positive to lead to a revival of “animal spirits.” History shows us that trying to run an extended zero-rate policy has serious consequences when the animal spirits return. The persistence of a zero-rate policy has led to very low borrowing costs as investor demand in search of income has depressed the yield of longer-dated benchmark securities, such as the two-year Treasury, to historicallylow levels (Exhibit 1, left chart). In addition, the US Federal Reserve’s accommodative policies have led to a dramatic increase in the monetary base, which has grown by over $3 trillion since 2009 (Exhibit 1, right chart). The consequence of maintaining a zero-rate policy for too
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Exhibit 1 An Extended Zero-Rate Policy Has Consequences Two-Year Treasury Notes Are at Historically Low Levels
Easy Money: US Monetary Base
(%) 6
($T) 5 4
4 3 2
2
1 0 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
0 1959
1970
1981
1992
2003
2014
Treasury Note data are as of 31 October 2014; and monetary base data are as of 30 September 2014 Source: Bloomberg, Federal Reserve Bank
Exhibit 2 The Fed Might Not Be Able to Expand QE without Causing Dislocation (% Par Outstanding Agency MBS Owned by the Fed) 40
$1,706B
(% Par Outstanding Treasuries Owned by the Fed) 40
30
30
20
20
10
10
0 2008
2009
2010
2011
2012
2013
2014
0 2010
$2,449B
2011
2012
2013
2014
As of 30 September 2014 Source: Bloomberg
long is two-fold. First, from an investment perspective, low interest rates can lead to irrational asset lending under exuberant conditions and subsequent price bubbles. Second, from a consumer demand perspective, the size of the monetary base represents a latent inflation risk, if exuberance leads to lending sufficient to expand this large monetary base back to money supply multiples consistent with pre-crisis levels (which has not been the case yet due to low levels of consumer demand). If credit conditions ease and lending accelerates too much, the current size of the monetary base can lead to an environment similar to the early 1980s that had exuberance and runaway inflation. Of the two, the risk of asset-price bubbles is the most worrisome. In the event of a future bubble burst, the Fed would need to respond with accommodative policy, however, in our view, the Fed is out of weapons to counteract such an event.
Why Quantitative Easing Ended The Fed responded to the 2008 financial crisis and capital markets dislocation, in some sense, by becoming the financial system, via its quantitative-easing programs (QE). However, given the decentralized
nature of the US economy, the Fed is limited in its ability to use its balance sheet to influence market outcomes. In 2013, our view was that further QE would be off the table as a further expansion of the Fed’s balance sheet would make them too influential in the pricing of mortgage-backed securities (MBS) and US Treasuries. From our perspective, it was clear that the unwinding of QE would remain on track regardless of economic conditions as a further expansion of the balance sheet could influence outcomes and lead to dislocations. At this juncture, the Fed owns 35% of the outstanding MBS market, and approximately 30% of the outstanding US Treasury market (Exhibit 2). Based on the US government’s own guidance, anything above these levels is akin to cornering the market. Although the Fed has continued to influence the front end of the yield curve through its zero-rate policy, it stopped short of distorting long-term rates by discontinuing QE. As such, the 10-year US Treasury continues to be more driven by natural market forces than Fed actions. We believe the 10-year US Treasury yield is at a level that reflects global economic and market conditions. However, the spread between the 10-year Treasury and 3-month T-bill at 2.3% is not;
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Exhibit 3 Long Rates Normalized in 2013; Short Rates Will Follow Yield (%)
Normal Projected Yield Curve
4 3
Yield as of 30 September 2014
2 1 0
0.5
2
5
10
30 Maturity (years)
Yield (%) 4 Normal Projected Yield Curve Yield as of 30 September 2014 3 2 1 0
0.5
bps 94 Difference
2
5
10
109
66
51
30 Maturity (years) 30
As of 30 September 2014 Normal projected yield curve based on Lazard estimates. Estimated or forecasted data are not a promise or guarantee of future results and are subject to change. Source: Lazard, Bloomberg
from a historical perspective this spread reflects periods commonly associated with US recessions marked by extremely accommodative Fed policies. In order to bring back policy to a neutral position, the Fed needs to tighten this spread. Given that the Fed has indicated that it will not use its balance sheet to do so, it will have to raise short-term rates to establish a neutral position consistent with today’s US growth environment. Exhibit 3 demonstrates the changes implied by this return to policy normalcy. The short end of the yield curve has a material gap to fill, as far as rate normalization. Importantly, conventional wisdom can lead some investors to purchase shorter maturity instruments in anticipation of a rising-rate environment, as theoretically, shorter maturity instruments have lower interest rate sensitivity (duration). However, investors are more likely to experience adverse price movement in the event of interest-rate normalization in the shorter end of the yield curve, given the magnitude of the upward move rates must take to return to normalcy.
Regulation Has Led to Intermediation Weakness Prior to the financial crisis, fixed-income dealers were encouraged to play a similar role to that of specialists in stock exchanges. In other words, they were encouraged to use their own capital to support
supply/demand imbalances in the markets and, importantly, act as shock absorbers to price movements during turbulent times. This practice led to some abuses by some dealers, whereby they irrationally created securities that were complex and, more importantly, that required their direct intermediation for liquidity. The collapse of the financial system in 2008 brought these abuses to the surface. After the crisis, however, regulation basically changed in a manner that was unexpected for institutional market participants. Rather than continue to encourage market making in standardized securities, regulation actually led to the demise of the proprietary trading desks in all fixed income securities. While on the surface the role of all prop desks were viewed as added risk to the financial system, in reality rational prop desks have historically played a pivotal role in reducing pricing volatility risks for investors during large trading flows of standardized fixed income assets during turbulent times. We have already experienced some of the results of this lack of market-making capacity. In 2008, we had a two-fold liquidity problem: (1) turning a fixed income claim into money and (2) mark-to-market impairment. Since then, individual investors, and investors in general, feel a lot more comfortable taking risks because of structures like exchange-traded funds (ETFs) and mutual funds. Although ETFs and mutual funds have solved the first problem, the second problem still exists since underlying assets have to be sold or bought in order to exchange an investor’s claim into money. Low liquidity of underlying components means that there can be sudden and dramatic price impacts to the upper-level structure (i.e., the ETF). Needless to say, many yield-oriented ETFs need to be assessed carefully with regard to their underlying exposures. As seen in Exhibit 4, despite small fluctuations in the 10-year US Treasury, ETF investors in yield-oriented
Exhibit 4 Small Fluctuations in the 10-year US Treasury Drastically Affect Yield-Oriented Investments Returns (%) YTD through 31 Aug 14
Sep 14
21 May 13 to 24 Jun 13
Bank Loans
1.96
-1.86
-1.91
High Yield Bonds
5.38
-2.57
-6.64
EM Local Currency Bonds
5.57
-4.00
-12.58
Global Consumer Staples
5.65
-1.96
-6.58
REITs
17.75
-6.92
-15.15
US Utilities
17.99
-2.53
-7.96
Change in 10-Year UST Yield (%)
3.03
2.34
2.34
2.49
1.93
2.54
As of 30 September 2014 Bank Loans = PowerShares Senior Loan Portfolio; High Yield Bonds = SPDR Barclays High Yield Bond ETF; EM Local Currency Bonds = Market Vectors Emerging Markets Local Currency Bond ETF; Global Consumer Staples = iShares Global Consumer Staples ETF; REITs = Vanguard REIT ETF; US Utilities = Vanguard Utilities ETF; High Yield Bonds = SPDR Barclays High Yield Bond ETF. The performance quoted represents past performance. Past performance is not a reliable indicator of future results. This information is for illustrative purposes only and does not represent any product or strategy managed by Lazard. Source: Bloomberg
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structures suffered abnormally large price effects. In September 2014, the 10-year US Treasury rate increased from 2.34% to 2.49%; however, due to selling flows higher-yielding ETFs suffered outsized negative returns relative to the overall change in underlying market rates. In other words, while investors could easily exchange their fixed income claims into money, they could not escape the mark-to-market impairment of the required trading flows of the thinly traded underlying assets. Recently, we saw that this price volatility phenomenon is not limited to higher yielding, thinly traded assets. While 10-year US Treasury securities appear well-supported based on their yield stability, we recently experienced an event that called this support into question. On 15 October 2014, the 10-year US Treasury yield opened the day at 2.22% and closed at 2.13%, which is hardly a move at all, but during intraday trading, there was short covering in the marketplace where the 10-year US Treasury moved 36 basis points. This is a price movement of over 3% in one day. Since the closing price was near its opening price, investors that are not actively involved in the intraday market are receiving a false sense of liquidity stability which in reality, does not appear to be present.
Why Own US Fixed Income? Historically, the US bond market, as defined by the Barclays US Aggregate Index, has had low correlations to other risk assets, like US equities, global equities, and hedge funds. Naturally, in strong equity markets such as the one in 2013, US fixed income lags. More importantly, the US bond market is much less volatile and more defensive than any other asset class. For instance, during the 2008 financial crisis US bonds returned 5% against the S&P 500 Index and MSCI World Index collapse of 37% and 40%, respectively (Exhibit 5). Forgoing a US fixed income allocation implies the investor is confident that his or her portfolio does not need this diversifying asset, that is, implicit confidence of no further adverse market environments (which is highly unlikely). Key to this diversifying outcome is that the Barclays US Aggregate Index, based on its construction, is a historical return representation of US investment-grade fixed income securities that have not suffered impairment. The index is dominated by US-dollardenominated fixed income securities that have returned coupon and principal in a timely manner and that have experienced liquidity during times of distress. When these conditions are met, investors are presented with what we believe is the most diversifying asset class in the world that is able to dampen the fluctuations of risk assets within an asset allocation context.
Perceptions and Reality In today’s bond markets, there is strong contrast between conventional and popular wisdom and reality. For instance, we believe the Fed is out of accommodative policy tools but the idea permeating markets is that the Fed is in control. Common thinking is that the fixed income market is liquid; however, regulation has impaired market-making (as discussed earlier). In effect, regulation has, in our opinion, been written to protect the financial system rather than the investor. In addition
to this false conventional wisdom, we will address three more dissonances between popular wisdom and reality in more detail in the pages ahead. These are: de-risking by going passive—but going passive in fixed income markets is a very active decision; investment-grade yield is defensive—but investment vehicles labeled as investment grade are not defensive if they are not actually composed of investment-grade securities; and high yield bank loans have gained popularity and investor momentum on the assumption that they will offer protection in market sell-offs—but these securities have historically lost sponsorship during such sell-offs. Unlike many equity indices, fixed income indices are not static. Equity indices are determined by a list of securities and inclusion rules. However, bond market benchmarks are dominated by issuance. The more an entity issues bonds, the larger weight it commands. Using one of the most visible fixed income benchmarks as an example—the Bank of America Merrill Lynch Domestic Master Index—we can illustrate some of the fluctuations in benchmark characteristics. In 2007, the components of the index made it more defensive than the index is today. At that time, the index had a higher yield, less interest-rate sensitivity (as shown by duration), and was more diversified (Exhibit 6). Although the make-up of the current index does not necessarily make it less defensive, it does make it less optimal from an expected return perspective. As the public sector increased issuance, it has come
Exhibit 5 US Investment-Grade Fixed Income Has Historically Provided Diversification Correlation Matrix (10-year period ending 30 June 2014)
Barclays US Aggregate
Citi WGBI ex-US Dollar
JP Morgan EMBI
S&P 500 Index
0.02
0.24
0.57
MSCI World Index
0.07
0.34
0.64
HFRX Global Hedge Fund
0.00
0.14
0.55
Unconstrained Bond Fundsa
0.44
0.51
0.84
Equity Markets
Hedge Funds
Adverse Return Years (%) 2008
Barclays US Aggregate
5.24
2011
2013
7.84
-2.02
S&P 500 Index
-37.00
2.11
32.39
MSCI World Index
-40.33
-5.02
27.37
HFRX Global Hedge Fund
-23.25
-8.87
6.72
Unconstrained Bond Fundsa
-16.64
0.89
-0.72
Citi WGBI ex-US Dollar
10.11
5.17
-4.56
JP Morgan EMBI
-10.91
8.46
-6.58
As of 30 September 2014 a Internally monitored universe based on Morningstar definition. The performance quoted represents past performance. Past performance is not a reliable indicator of future results. This information is for illustrative purposes only and does not represent any product or strategy managed by Lazard. Diversification does not guarantee profit or protect against a loss in declining markets. Source: Lazard, Morningstar, Bloomberg
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to dominate the index weights—along with US governments, foreign issuers, in many cases banks, which are extensions of sovereigns from centralized economies, have become a disproportionate component of the index. So for an investor worried about interest-rate risk and who elects to “hide” in this index, the key characteristics of yield, duration, and diversification (index sector composition) all point to higher and not lower interest-rate risk. Flows into short-duration ETFs and mutual funds have been very strong in recent years due to their convenience and perceived liquidity and quality (investment grade). However, the designation of “investment grade” for a mutual fund can be achieved as long as the majority of the underlying securities are investment grade without regard for its structure.2 As discussed, there are looming rising-rate risks in the
The natural buyer of floating-rate securities are levered investors such as financial institutions, hedge funds, and REITs which are interested in owning floating-rate assets principally because these institutions rely on borrowing and floaters provide income/earnings protection as rates rise. More recently, floating rate or leveraged loans have gained popularity with other investor groups, based on the perception that these securities should experience less mark-to-market interest-rate sensitivity in a sell-off. But the reality is that floating-rate loans have a lower absolute yield and experience greater mark-to-market downside risk (than fixed-rate loans and bonds) during adverse market events. In general, floaters lose mark-to-market sponsorship in down markets when their natural buyers lose access to financing and are insufficient to absorb the supply of sellers. Exhibit 8 compares historical performance of leveraged loans and fixed-rate, non-distressed high yield indices. It is evident that floaters perform worse, on a cumulative basis and in individual years. This is even more striking in the 2008 sell-off, when US leveraged loans declined 29% compared to a US nondistressed high yield decline of only 19%.
Exhibit 6 Bond Indices Are Determined by Issuance and Change Over Time As of 31 December 2007
As of 30 September 2014
Yield: 4.87% Effective Duration: 4.7 years Foreign 8%
Yield: 2.32% Effective Duration: 5.7 years Foreign 13%
TSY 24% Other US 34%
US Agency MBS 34%
Other US 23%
short end (2–3 years) of the yield curve, dangers around liquidity, and dangers of yield-chasing in risk assets. So, it is important to examine the underlying investments of mutual funds that fall into investment grade short duration universes. Exhibit 7 illustrates this for a small sample of short duration US investment grade mutual funds. The attractive yield component of Fund A (3.70%) may not look that favorable in the face of its underlying composition with elevated weights in high yield and commercial mortgage-backed/asset-backed securities. This is a clear example where the investment grade nomenclature can mislead investors to perceived safety. By contrast, Fund D may not have an attractive yield (0.55%), but its underlying components are more consistent with a safer, non-impairment allocation. There is no magic; seeking higher yield means a fund is sacrificing credit quality or liquidity.
TSY 40%
US Agency MBS 24%
As of 30 September 2014 Source: BofA Merrill Lynch
Exhibit 7 Not All Investment-Grade Funds Are the Same Characteristics
Sector Weights (%)
Yield (%)
Duration (years)
BBB Corporate
High Yield
1-3 Year US Treasury Index
0.44
1.91
0.00
0.00
Barclays US Aggregate Index
2.36
5.54
12.00
US Investment-Grade Short Duration Fund A Mutual Funds Short Duration Fund B
3.70
2.14
1.50
Short Duration Fund C
0.88
Short Duration Fund D
0.55
Performance (%) CMBS/ ABS
2008
1H 2013
0.00
6.61
0.00
0.00
2.20
5.24
-2.44
34.70
19.70
28.70
-1.87
-0.30
2.54
10.00
7.00
13.80
-1.28
-1.42
1.96
12.90
0.50
24.00
-3.66
-0.20
0.75
18.00
0.00
0.00
6.31
0.32
As of October 2014 The indices listed are unmanaged and have no fees. One cannot invest directly in an index. This information is for illustrative purposes only and does not represent any product or strategy managed by Lazard. Source: Lazard, Lipper, Morningstar, Bloomberg
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Exhibit 8 Fixed Rate Instruments Have Historically Performed Better than Floating Rate (Leveraged) Loans (%) 100 75 50 25 0 -25 -50
YTD 2014
2013
2012
2011
2010
2009
2008
2007
2006
10 Years
Conclusion A US fixed income allocation remains a key building block for asset allocators, given its diversifying properties. However, investors should be mindful of the following: rising short interest rates are inevitable and lead to unexpected outcomes; regulation-induced liquidity constraints have raised the volatility profile of fixed income outcomes; and popular ideas, conventional thinking, and labels may have become unreliable. Key to achieving the diversifying properties of an investment allocation is a fundamental understanding of the composition of the fixed income investment portfolio. In that regard, true bottomup security selection focused on current behavioral drivers will help avoid the current non-diversifying risks inherent in fixed income market allocations.
US Non-Distressed High Yield US Leveraged Loans As of 30 September 2014 10-year period is cumulative. US Non-Distressed High Yield = ML BB/B Non-Distressed High Yield Index; US Leveraged Loans = Credit Suisse US Leveraged Loans Index. The performance quoted represents past performance. Past performance is not a reliable indicator of future results. This information is for illustrative purposes only and does not represent any product or strategy managed by Lazard. Source: Lazard, Bloomberg, Zephyr
Notes 1 Source: Federal Reserve Bank, Bloomberg, as of 30 September 2014 2 The Investment Company Institute defines investment-grade mutual funds as those with two-thirds or more of their portfolios in investment-grade securities. Lipper sets this threshold at 85% for their core bond fund category and 65% for core plus bond funds. Source: ICI (http://www.ici.org/research/stats/iob_update/iob_definitions), Lipper (http://www.lipperweb.com/docs/ Research/Methodology/Lipper_Classification_Definitions_v2_2_July_2014.pdf)
Important Information Originally published on 19 November 2014. Revised and republished on 21 November 2014. Information and opinions presented have been obtained or derived from sources believed by Lazard to be reliable. Lazard makes no representation as to their accuracy or completeness. The securities and/or information referenced should not be considered a recommendation or solicitation to purchase or sell these securities. It should not be assumed that any of the referenced securities were or will prove to be profitable, or that the investment decisions we make in the future will be profitable or equal to the investment performance of securities referenced herein. An investment in bonds carries risk. If interest rates rise, bond prices usually decline. The longer a bond’s maturity, the greater the impact a change in interest rates can have on its price. If you do not hold a bond until maturity, you may experience a gain or loss when you sell. Bonds also carry the risk of default, which is the risk that the issuer is unable to make further income and principal payments. Other risks, including inflation risk, call risk, and pre-payment risk, also apply. High yield securities (also referred to as “junk bonds”) inherently have a higher degree of market risk, default risk, and credit risk. This material is for informational purposes only. It is not intended to, and does not constitute financial advice, fund management services, an offer of financial products or to enter into any contract or investment agreement in respect of any product offered by Lazard Asset Management and shall not be considered as an offer or solicitation with respect to any product, security, or service in any jurisdiction or in any circumstances in which such offer or solicitation is unlawful or unauthorized or otherwise restricted or prohibited. Australia: FOR WHOLESALE INVESTORS ONLY. Issued by Lazard Asset Management Pacific Co., ABN 13 064 523 619, AFS License 238432, Level 39 Gateway, 1 Macquarie Place, Sydney NSW 2000. Dubai: Issued and approved by Lazard Gulf Limited, Gate Village 1, Level 2, Dubai International Financial Centre, PO Box 506644, Dubai, United Arab Emirates. Registered in Dubai International Financial Centre 0467. Authorised and regulated by the Dubai Financial Services Authority to deal with Professional Clients only. Germany: Issued by Lazard Asset Management (Deutschland) GmbH, Neue Mainzer Strasse 75, D-60311 Frankfurt am Main. Japan: Issued by Lazard Japan Asset Management K.K., ATT Annex 7th Floor, 2-11-7 Akasaka, Minato-ku, Tokyo 107-0052. Korea: Issued by Lazard Korea Asset Management Co. Ltd., 10F Seoul Finance Center, 136 Sejong-daero, Jung-gu, Seoul, 100-768. United Kingdom: FOR PROFESSIONAL INVESTORS ONLY. Issued by Lazard Asset Management Ltd., 50 Stratton Street, London W1J 8LL. Registered in England Number 525667. Authorised and regulated by the Financial Conduct Authority (FCA). Singapore: Issued by Lazard Asset Management (Singapore) Pte. Ltd., 1 Raffles Place, #15-02 One Raffles Place Tower 1, Singapore 048616. Company Registration Number 201135005W. This document is for “institutional investors” or “accredited investors” as defined under the Securities and Futures Act, Chapter 289 of Singapore and may not be distributed to any other person. United States: Issued by Lazard Asset Management LLC, 30 Rockefeller Plaza, New York, NY 10112.
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