Bond Investors: Manage Volatility If You’re Concerned about Liquidity

As the political crisis between Greece and greater Europe continues to evolve, markets around the world are exhibiting ever greater levels of volatility. As Mario Draghi commented, “We should get used to periods of higher volatility.”¹ We agree, and given fixed income’s typical role in a portfolio as the low volatility component, it will be extra challenging for investors if volatility in the bond market picks up. For U.S. bond investors, the concern over the last several weeks² has been the potential for gaps in liquidity in the bond market. So far, no one has been able to provide a satisfactory answer to this industry-wide question. In response, we believe investors should focus on the likely result of potential gaps in liquidity, which is a rise in volatility in their bond portfolio. In today’s bond market, the greatest source of volatility is interest rate risk. In our view, investors should consider hedging interest rate risk to manage potential gaps in liquidity.   Why Are Bond Markets So Volatile? When talking about the current market environment, it is important to think about the role fixed income plays in many investors’ portfolios. Historically, bonds in traditional asset allocation have often served as ballast for the more volatile equity portion of the portfolio. However, as we discussed previously, this concept relies on two principles that may no longer be true: 1) reasonable income potential, and 2) modest correlation to riskier assets such as U.S. equities. As we inch ever closer to a change in Federal Reserve (Fed) policy, the early days of trend reversals in markets can be particularly volatile as investors try to exit before the crowd. This desire, combined with back-to-back years of record bond issuance and a decreased willingness by certain market participants to provide liquidity, will likely result in greater price gaps as markets attempt to react to news. Also, as we mentioned earlier, with coupon rates across a majority of fixed income benchmarks at their lowest levels in history, interest income provides very little cushion for changes in bond markets. As a result, it may appear painfully obvious that investors concerned about volatility in the bond market should hedge interest rate risk.   Risk vs. Return in Unhedged, Zero Duration & Negative Duration Strategies In our view, we are currently approaching an extremely uncertain market environment: questions about public finances in Europe, an imminent restructuring in Puerto Rico and, last but not least, the first change in U.S. monetary policy in nearly nine years. With all of this in mind, we continue to advocate that investors hedge interest rate risk in their bond portfolios. Below, we illustrate the impact of hedging or altering the interest rate risk profile of core investment-grade strategies³ and U.S. high-yield strategies over the period from January 31 to June 30 of this year.   Core and High-Yield Bond Returns: 1/31/15–6/30/15 For definitions of terms in the chart, visit our glossary. This table clearly shows the value of these strategies during a period of rising rates. In 2015, U.S. rates bottomed on January 30. Since that time, interest rate risk resulted in a drag on performance, with the benchmark aggregate bond index down over 2% over the period.⁴ A zero duration approach to the Barclays U.S. Aggregate Index significantly reduced volatility while preserving returns; a negative duration strategy would have actually increased in value by over 4 percentage points over the period. Among U.S. high-yield strategies, investors were able to preserve a greater portion of bond returns compared with an unhedged strategy as nominal rates increased. Over that period, the primary driver of high-yield returns was credit risk. Since increases in nominal interest rates at the short end of the yield curve were more muted, the zero duration approach was marginally more volatile. In our view, should rates rise at the short end as a result of Fed rate hikes, we believe volatility could be lower than with the unhedged approach with greater total returns. As is the case with any investment, investors can be compensated by the market for taking a risk. Over the last 30 years, investors have continually been rewarded for assuming ever greater amounts of interest rate risk. Due to the current uncertainty in global fixed income markets, we continue to believe that investors should reduce interest rate risk via hedged strategies. For investors with a broader portfolio of interest rate-sensitive investments, negative duration strategies could serve as a broader portfolio hedge.         ¹Mario Draghi, ECB press conference, 6/3/15. ²As of July 10, 2015 ³As proxied by the Barclays U.S. Aggregate Index. ⁴As represented by the Barclays U.S. Aggregate Index, as of 6/30/15.