Three threats to bonds
Typically, when stocks decline, we see investors rushing to buy US Treasury bonds and other safe assets. This tendency of bonds to rally when stocks drop – the negative correlation between bonds & equities – is the basis for a conventional allocation of 60% to stocks and 40% to bonds. There is a diversification benefit from bonds.
In recent years, bonds have performed so well amidst sluggish economic growth that some investors & managers even flip the ratio, giving a larger allocation to bonds. The rationale is that bonds have historically been less volatile than equities and so can offer greater risk-adjusted returns. By increasing allocations or “levering up” in bonds, each asset class in the overall portfolio can make an equal contribution in volatility terms.
The challenge for investors today is that both of those benefits from bonds, diversification and risk-reduction, seem to be weakening, and this is happening at a time when positioning in many fixed income sectors is incredibly crowded, making bonds more vulnerable to sharp, sudden selloffs when active managers rebalance.
1. Diversification: the core premise of every 60/40 portfolio is that bonds can hedge against risks to growth and equities can hedge against inflation; their returns are negatively correlated. But this assumption was only true over the past two decades and was mostly false over the prior 65 years (Chart 4). The big risk is that the correlation could flip, and now the longest period of negative correlation in history is coming to an end as policymakers jolt markets with attempts to boost growth (Table 1).
2. Volatility: in the past 3 years, the risk-adjusted returns in Treasuries were worse than in every other asset class except commodities (Table 1); the future may look very much like the recent past, as duration risk is at record highs (G0Q0 = 7yrs), forward-looking implied volatility is at 4-year highs, and the yield per unit ofrisk is worse than in every other part of fixed income (Chart 10). Long Treasury bond buyers recently enjoyed one of the best periods of returns in history, something unlikely to be repeated (Chart 5). These are not far-off risks, they are happening today: for example, if you bought a 10-year Treasury note on Sept. 3rd, you have already had to endure losing 3.0% on that investment over the subsequent 10 days…in order to make just 1.5% over the next 12 months.
3. Positioning: to achieve the same yield over the past 20 years, investors have had to take on increasingly more risk (Chart 6). Global institutional investors are crowded into US$ bonds (1.4sd) with record exposure to US vs. European bonds (link); asset managers & private clients have pulled $208bn from equity funds and bought $339bn in bond funds YTD; and the share of Treasury debt in aggregate bond portfolios is now more than 40%, near a 20-year high. Crowded positioning means that natural swings in bond prices may be exacerbated as active investors rebalance their holdings or the macro outlook changes.
Three paths to regime change
In spite of these risks, it may not yet be time to get out of Treasuries. Our colleagues in US rates strategy expect 10-year yields to fall another 25bps in coming quarters to 1.25% based on low economic growth, a dovish Fed, and the lack of alternatives for foreign investors to the US dollar. We accept those arguments, which were reinforced last week by the worst ISM manufacturing PMI outlook since 2009.
However, we are also alert to potential catalysts that could send bonds into a new regime of higher yields, causing unnecessary portfolio pain:
1. Housing boom: central bank “impotence” is an important theme for 2020 but the Fed is not powerless yet…the current mortgage refinancing boom is on pace to be the largest in 6 years, and we expect 2 more Fed cuts in 2019, which could fuel more refinancing and consumer spending in 2020 (Chart 7).
2. Wage inflation: private-sector wages are growing 3.5% (fastest since 2009) and in July 2.4% of workers quit their jobs for better pay elsewhere …implies almost 4% wage growth in Q1’20 (Chart 8). The Fed well let inflation run hot to repair damage from the GFC.
3. Fiscal policy: consensus says impeachment & trade war will distract DC from anything else. But a Trump pivot on trade is plausible, and if the economy does weaken, the President may ask Congress to pass broad-based personal tax cuts,something Democrats would find difficult to oppose in an election year. $1 of corporate tax cuts produces just $0.32 of economic activity, but $1 of personal tax rebates generates $1.80 of GDP (Moody’s/CBO).
Building a better bond shelter
The risks to conventional portfolios also represent opportunities, whether or not the scenarios above occur. Consider some alternative ways to access yield, in order of least to most risk-averse:
1. Buy higher-yielding dividend stocks in bombed-out cyclical sectors: we may be closer to late- than mid-cycle but equity risk is still worth taking, especially in companies with attractive yields at fair multiples. Michael Hartnett suggests global cyclical value dividend payers will outperform in a selloff as people are forced to sell what they own (defensives & tech) not what they don’t (financials, industrials, materials – Chart 9).
2. Buy short-duration HY corporate bonds & floating-rate loans: in a ratesup world, credit risk is preferable to duration risk, too (Chart 10). US corporate leverage has actually declined ex-growth sectors (tech, healthcare, and consumer discretionary) and in HY materials and utilities have improved leverage ratios notably in recent quarters. HY spreads are 122bps above postGFC lows and duration is at record lows (H0A0 = 3.5 years). Bank loans are reviled (record $26bn fund outflows YTD, 22% of AUM) and are a contrarian buy on plunging supply, our desire to fade recession fears, and the underpriced risk of a 2020 spike in yields.
3. Buy quality munis: investors who prefer the risk of higher rates to risks in credit or equities should consider long-dated municipal bonds at yields above Treasuries (Chart 11). Our strategists expect munis to benefit from a flight to quality in case recession risk does rise; AA-AAA bonds traded 20bp below Treasuries at the trough in Q1’16, and inflation breakevens today imply a spread 11bp tighter than current market pricing (Chart 12).
Food for thought.