KEY TAKEAWAYS

  • The year 2020 saw stark differences in returns between fixed income categories—some of the largest in history.
  • This unprecedented return dispersion is a reminder that fixed income asset classes can behave very differently, so allocations should be tailored to an investor’s goals.
  • A one-size-fits-all approach to fixed income may lead to suboptimal results.

The first half of 2020 saw nearly unprecedented return dispersion across certain segments of fixed income. Globally, government bonds strongly outperformed corporate bonds in the first quarter. In particular, the spread in first-quarter returns between US Treasuries and US corporates was more than 11 percentage points, the largest quarterly return difference between the two in a sample going back a half century. Of course, the second quarter saw a sharp bounce-back for US credit, with US corporates outperforming US Treasuries by more than 7.7 percentage points. Historically, this represented the second-largest quarter of outperformance for US credit.

These outcomes are a reminder that fixed income asset classes can behave very differently, and that the choice of fixed income should be tailored to one’s specific needs and goals. This also implies that the framework for evaluating fixed income should be dictated by one’s goals. For example, the characteristics of a fixed income strategy that appeals to investors eyeing capital preservation may differ substantially from those of a strategy seeking to manage future cash flow liabilities. One’s investment goals should drive the evaluation process in fixed income investing. Three case studies illustrate this principle.

A HOLISTIC VIEW OF FIXED INCOME

For investors seeking return stability from their fixed income, a key part of the evaluation is their overall asset allocation. Components elsewhere in an investor’s portfolio may be a major determinant in how adding fixed income impacts asset allocation volatility.

Let’s take, for example, the decision of where to settle when it comes to duration and credit quality—how much exposure to longer-dated or lower-rated bonds should an investor pursue? As the top panel of Exhibit 2 illustrates, a global aggregate bond index holding a wide range of maturities and credits has had higher return variability than a shorter-term, higher-quality government bond index. Looking only at this data, an investor prioritizing return stability may view the government bond allocation as more appealing.

However, this sleeve of fixed income is unlikely to be the only component in an investor’s portfolio. Many investors may also hold stocks, and when held in meaningful proportions, equity components can often be the main driver of portfolio volatility. As a corollary, the impact on overall volatility from duration or credit exposure within fixed income can be less meaningful for portfolios with equity-heavy allocations. The bottom panel of Exhibit 2 helps illustrate this for two 60/40 stock/bond allocations. Return volatility is very similar, whether the fixed income allocation consists of short-term government bonds or a more core approach that holds a broader portion of the bond market.

LET’S GET REAL

Some investors may prioritize preservation of purchasing power, or the amount of goods and services their savings can afford in the future. In this case, fixed income may be better evaluated through the lens of uncertainty in real, rather than nominal, returns. As Exhibit 3 highlights, inflation can substantially impact a fixed income portfolio’s growth of wealth in real terms.4Dimensional Fund AdvisorsPlease see the end of this document for important disclosures.

Inflation-hedging assets such as Treasury Inflation-Protected Securities (TIPS) can help mitigate the impact of unexpected changes in inflation. A TIPS bond’s face value and subsequent interest payments are adjusted in response to changes in the Consumer Price Index (CPI). The result is TIPS holders get paid actual inflation—based on the increase or decrease in the CPI.
TIPS eliminate the inflation-related component from real return volatility. This can be observed in the returns for TIPS of various maturities shown in Exhibit 4—all have had lower volatility in real vs. nominal returns. In other words, TIPS have had lower uncertainty in units of the goal (real wealth) for investors focused on future purchasing power.
Another observation we can glean from these data is that the difference between nominal and real return volatility is relatively smaller for indices composed of longer-maturity TIPS. While inflation protection removes the inflation component of real return uncertainty, the component related to changes in real interest rates remains. Sensitivity to real rates increases with duration, and this source of variance is present whether returns are assessed in real or nominal units.
Whether an investor’s goal is real or nominal in nature, longer-duration bonds increase volatility in wealth units, or the value of an account balance. But what if progress toward the goal is not well specified in wealth terms?

INCOME IS THE OUTCOME

Let’s say an investor’s goal is to prepare for retirement income. Supporting consumption in retirement requires funding a string of cash flows, which represents a future liability for this investor. Risk management in this scenario can mean reducing the uncertainty around the amount of future income that can be drawn from the investor’s current savings. Consequently, the risk-mitigating asset for this goal can be a portfolio of assets whose value changes commensurately with the cost of funding future income.
Exhibit 5 illustrates the role this plays in the evaluation of fixed income. When viewed in wealth terms, representing the magnitude of fluctuation in one’s account balance, One-Month US Treasury Bill (T-bill) returns have been very stable. For investors prioritizing capital preservation, this is an appealing characteristic.

A different story emerges when evaluating T-bills through the lens of supporting future liabilities. Since the goal is to reduce the uncertainty of meeting these liabilities, a more sensible metric may be the volatility of returns in income units (the amount of income that can be drawn in the future), scaling the T-bill returns by changes in the price of an income stream sustainable for 25 years of retirement. Income unit returns are much more volatile for T-bills. Because the duration of T-bills is far shorter than that of the liability, T-bill returns cannot keep up with changes in the value of the liability. The result can be substantial uncertainty related to how much one’s current savings can support in terms of consumption during the retirement period if invested in T-bills. So, what one investor might consider a low-risk asset may pose considerable risk to another investor with different goals.

IF THE SHOE FITS

The year 2020 provided all sorts of unsolicited reminders about the importance of various investment principles, from sticking to an investment approach to maintaining a disciplined focus on value. Global bond markets were no exception, as the extreme return deviations among different segments of fixed income reminded us that fixed income allocations should be matched to the investor’s particular goal. As with clothing, a one-size-fits-all approach to fixed income may lead to suboptimal results. To that end, it’s important for an investor’s goals to play a central role in how fixed income choices are evaluated. After all, one person’s fashion statement is another person’s faux pas.

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