Jim Nelson: Bonds can play an important role in a well-diversified investment portfolio. They can help offset the volatility of stocks. But how do you choose from the many types of bonds?
Hello, I’m Jim Nelson, and welcome to Vanguard’s Investment Commentary Podcast series. In this month’s episode, which we’re taping on July 18, 2017, I’m joined by Kevin DiCiurcio, an investment analyst from Vanguard Investment Strategy Group. Kevin is here to explain the role of different types of bonds in investor portfolios. Hi, Kevin. Thanks for joining us.
Kevin DiCiurcio: It’s my pleasure, Jim. Thanks for having me.
Jim Nelson: So, first question: Many investors choose a fund or a couple of funds to give them broad exposure to the bond market. Why are these types of funds so popular?
Kevin DiCiurcio: Bond markets offer investors a few opportunities to earn extra yield compensation over what’s considered the risk-free interest rate, typically referenced as a 3-month Treasury security or a 1-month Treasury security. An investor can buy longer-maturity bonds and take on the additional duration risk, they can add credit risk to a portfolio, and they can also gain exposure to the lesser-known compensation—this is taking on prepayment risk in mortgage-backed securities.
An aggregate bond market portfolio that you describe combines exposure to all of these: owning U.S. Treasury securities, corporates, asset-backed, commercial and residential mortgage-backed securities and it really is a great starting point for most investors because of this broad diversification appeal.
Jim Nelson: So international bonds are also part of a broad fixed income portfolio. Why not stay close to home with domestic bonds?
Kevin DiCiurcio: We talk about this with clients quite a bit. Vanguard over the years has really moved to a global bond portfolio, reducing the amount of home bias. We acknowledge that home bias does exist in almost all markets, but it’s our goal to reduce that home bias because of the diversification properties.
Now investors have observed the longer duration, lower yield levels of international bond portfolios and they may rightly question their inclusion in their portfolios based on those characteristics alone. So allow me to address those two points, if I may.
Because of its composition, longer duration does not necessarily mean greater risk in terms of greater return volatility. In international bond portfolios, duration really becomes a weighted average exposure to interest rates among several countries, many of which have independent monetary policies and economic processes. Therefore, this aggregate exposure really naturally diversifies one another, to the point that you actually see that it leads to a bond portfolio with less return volatility than the U.S. bond market, even though it is perceived to have more duration. So combining the U.S. dollar-denominated and international bonds provides powerful diversification properties.
With regard to the lower yield levels, we do acknowledge that global yields are very low, based on historical standards. So lower yields than the U.S. may be problematic for some income-sensitive investors. We generally recommend a total return approach for long-term investors with stock and bond portfolios. Since equities really drive the risk and return, we think that the improved diversification is more valuable than the yield that an investor may be giving up.
Jim Nelson: So let’s talk about Treasuries. People around the world choose Treasuries for some part of their portfolios. What sorts of things should drive the decision to get into Treasuries?
Kevin DiCiurcio: For long-term investors, Treasuries are an essential part of the diversified bond portfolio. It’s really the one sector in the broad U.S. market that offers pure exposure to interest rates. And it’s the exposure to interest rates that provides the best diversification to equity risk.
With the U.S. dollar as a global reserve currency, U.S. Treasuries also have this flight-to-quality characteristic, becoming a popular liquidity preference during times of uncertainty and the large drawdowns in the equity market. When you look at the worst months for equity returns—we looked at the worst 10% of monthly equity returns—and then you evaluate the opportunities that are available in the investment-grade bond market, broad U.S. Treasury exposure has historically produced the highest average returns during those months of really poor equity performance.
That said, it’s very difficult to time these equity market corrections. And we found that you also don’t really need to have Treasury exposure exclusively to have this ballast in your portfolio. Aggregate U.S. bond market exposure has historically produced positive returns on average during those worst-performing equity months.
Jim Nelson: So what’s been happening with the yield curve for Treasuries lately, and what does the shape of that yield curve mean for investors?
Kevin DiCiurcio: Long-term yields really started rising last summer. And we’ve been going through this since 2008, since the Global Financial Crisis. The Federal Reserve in its monetary policy has tried to be very accommodative, provide a lot of liquidity to the market and the economy, so as to induce or spark future economic growth, inflation expectations. So yields have been up and down really since the financial crisis.
The 10-year Treasury yield peaked around 2.6% early in 2017. But over the last few months, trading has really consolidated in a very tight range between 2.2% and 2.4%, so that volatility has gotten really low.
We have seen some flattening between the shorter-term and longer-term yields, though the yield curve itself is still upward-sloping. And when it is upward-sloping, there are expectations for a certain amount of rising interest rates. That’s already priced into the market.
This is often misunderstood, but for an investor to try to successfully time interest rate moves facing this upward-sloping yield curve, underweighting duration or going short duration will outperform only when rates rise faster than what’s already priced in. And going longer duration outperforms if rates fall or stay the same. Timing this correctly is very difficult to do, which is why we suggest broad exposure across the yield curve for investors with intermediate-term time horizons.
Jim Nelson: How does what’s happening with Treasuries affect the corporate bond market?
Kevin DiCiurcio: Generally speaking, the pricing of U.S. corporate bonds is influenced by what happens with Treasury yields, because they’re both exposed to the same interest rate risks. As prevailing rates on U.S. Treasury bonds change, the price of corporate bonds will change along with it, based on its own duration characteristics.
The difference for corporate bonds is they’re also exposed to factors that are affecting credit risk in the market and to the issuer specifically. So as credit risk changes, it’ll impact the prices of corporate bonds in addition to the effect that interest rate movements have in the Treasury market.
Jim Nelson: What are some of the reasons investors choose corporates for their portfolios?
Kevin DiCiurcio: From a portfolio construction standpoint, choosing corporates or choosing non-market-cap-weighted exposure, you generally do it for two reasons. First would be for diversification. When you add corporates to a Treasury bond portfolio, it actually results in a portfolio that exhibits lower return volatility than an all-Treasury portfolio that has similar duration. So, really, the addition of bonds with credit risk actually diversifies your Treasury holdings.
The second reason would be for return enhancement. Historically speaking, over long enough time horizons, corporate bonds have provided a premium over similar-duration Treasury bonds.
Jim Nelson: Let’s turn to municipal bonds. What special advantages and risks do they have for investors?
Kevin DiCiurcio: The tax-exempt municipal bond market is unique to the United States. The distinguishing characteristic of muni bonds is that the income generated for most bonds is exempt from federal income tax. In some cases, individuals may even be exempt from state income tax as well. But otherwise, in terms of interest rates and risk, the same factors apply to muni bonds as they do to the taxable bond markets. Economic growth, inflation, monetary policy are all still important drivers to the muni bond market.
When you look at the yields, muni bonds generally have lower yields than similar-maturity Treasuries, but this is more than offset by the tax benefit. So once you adjust yields for this tax equivalency, there does seem to be positive yield compensation above Treasuries just like a taxable corporate would have.
This can be attributed, similarly, to credit risk and illiquidity. But relative to the corporate bond market, the muni bond market’s much more fragmented. It’s less liquid.
Even though they seem to be less liquid, default rates have historically been much lower in the muni market than corporates with higher recovery rates. So the credit risk historically has not been as much as the taxable corporates.
Jim Nelson: So you mentioned about default rates. What’s been going in with the municipal market these days?
Kevin DiCiurcio: Yeah, it’s interesting. We see a lot of headlines about underfunded pension liabilities, budget deficits presenting financial challenges, in particular the state of Illinois recently. We certainly thought the dire forecasts in 2010 were a little overblown, and they didn’t quite play out in massive defaults as was predicted by some pundits.
Now, several years later, we still think low default rates will persist in the future, but there will be some high-profile cases because financial difficulties haven’t really been addressed since the financial crisis. So in these cases, states generally have the ability to increase taxes, they can cut spending in certain areas, and these are all positive credit drivers. So it’s something that we’re watching closely but do not believe there are any systemic real issues at the moment.
Jim Nelson: The Fed recently bumped up the fed funds rate. What impact has that had on the bond market, and how should those types of changes affect investors’ decision-making process?
Kevin DiCiurcio: The key message here, I think, is that the whole yield curve does share a connection to what the Fed is doing with its federal funds rate. They’re both related to what the expectations are for the economy and inflation. That’s how the Fed is setting their interest rate policy. They have moved up and down historically through time. So all bond investors should be cognizant of what the Fed is doing with its monetary policy, specifically what it’s doing with its interest rate policy.
That being said, interest rates along the yield curve may behave differently. They have varying sensitivity to changes in what the Fed is doing with its fed funds rate.
Jim Nelson: How does that work?
Kevin DiCiurcio: So the short end of the yield curve, 3 months to 2 years, is generally the most responsive to Fed policy. These are competing instruments. Longer-term bond yields, though, they may not respond immediately to changes in Fed policy. And this is generally what we’ve seen with the last couple of rate hikes. There’s been two this year so far, two quarter-point hikes of 50 basis points in total, 0.5%, and we have not seen long-term yields to 10-year specifically react to those hikes. Inflation expectations and long-term economic growth expectations play a larger role in long-term bond yields.
So since these longer-term interest rate movements are very difficult to predict, we would advocate that investors with intermediate time horizons think about the total returns of their bond portfolio. If longer-term interest rates begin to rise, you will experience those painful capital losses in your portfolio. But over time, bond investors want higher coupons because they generate more yield, ultimately more total returns. So as those higher coupons begin to replace the lower coupons in your portfolio and those proceeds are reinvested, your higher income returns can eventually make up for those early price losses.
Jim Nelson: The other news is that the Fed is going to start to unwind their bond holdings that built up during the quantitative easing period. How might that affect the market and investors’ decisions for their portfolios?
Kevin DiCiurcio: Yeah, we certainly live in interesting times in this regard. Since the Global Financial Crisis, the Fed has executed a few very large bond-buying programs known as quantitative easing, or QE for short. Counterintuitively to some during this time, given the systematic buying by the Fed, interest rates actually rose. And that’s because of expectations for increased inflation.
Now it seems that the Fed is committed to shrinking their balance sheet back to lower levels. They certainly don’t expect to get back to pre-Global Financial Crisis levels, but they are committed to unwinding. And they’re doing this by not reinvesting the coupon income on the bonds that they own and also not reinvesting the principal proceeds when the bonds mature over the next several years.
By all accounts, this is intended to be a slow, deliberate process, and the Fed will continue to be very transparent about it in its forward guidance. Now, our view is we would expect small increases in long-term bond yields due to this unwind. But our fair value of the 10-year Treasury remains in the 2.5% range, so there’s certainly room for interest rate increases to still be within that fair value.
An argument can be made that given the transparency and the forward guidance, that the market has already priced in the impact of the unwind. That’s how financial markets tend to work. Information is discounted into prices pretty quickly, and we’ll see about that.
But another consideration that we’re thinking about are the implications of possible unintentional coordination of global central banks around the world tightening monetary policy at the same time. They would be doing this at extremely low levels of interest rate volatility. So given the low volatility environment, it’s certainly conceivable that coordinated tightening could introduce more rate volatility into the market.
Jim Nelson: So we’ve covered a lot of territory in the podcast. Any final thoughts on choosing bonds for a portfolio?
Kevin DiCiurcio: Yeah. I know that there are other portfolio objectives, but I always go back to the role of bonds and what they provide in broad stock and bond portfolios.
So for total-return investors with this type of portfolio, equity risk will be the primary driver of risk and return. Even in a balanced 60/40 bond portfolio, it’s going to move how the returns in the equity market move. But the inclusion of Treasury and investment-grade-credit bonds in the portfolio can be used to align the portfolio’s risk to one’s risk tolerance.
So even though equities are going to drive risk and return, bonds will help an investor target an amount of return uncertainty that he or she may be comfortable with. This type of bond exposure has also historically helped offset the impact of large equity drawdowns and the impact they would have on a portfolio, because investment-grade bond returns have been positive on average during months of really poor equity returns. So diversification, targeting the amount of risk or uncertainty that you’re comfortable with, and also the ballast in the portfolio, are really the role of bonds.
Jim Nelson: Well, thanks so much, Kevin, for joining us and sharing your insights today.
Kevin DiCiurcio: Thank you, Jim. It’s been a pleasure.
Jim Nelson: We hope you’ve enjoyed this Vanguard Investment Commentary Podcast. Be sure to check back with us each month for more insights on the markets and investing. And, remember, you can always follow us on LinkedIn and Twitter or visit our website at any time. Thanks for listening.