From Bleak to Dire
Over the coming decade or two, bonds are unlikely to fulfill their dual role of income and capital preservation. Bond investors will be forced to choose between income or capital preservation, and there is a good chance they could end up with neither.
In the summer of 2019, Swan Global Investments published a well-received white paper, “The Bleak Future of Bonds.” The main thesis was the economic fundamentals are unfavorable for fixed income securities across the credit spectrum creating portfolio construction challenges for many advisors.
Less than a year later, the global economy was devastated by the coronavirus pandemic. Unfortunately for investors, the monetary and fiscal consequences of the pandemic have made the outlook for bonds even worse. The trends and concerns raised a year ago have been exacerbated by the pandemic. What was bleak a year ago is dire today.
This brief update revisits the main tenets of “The Bleak Future of Bonds” paper and provides updates to some key numbers in the aftermath of the COVID-19/coronavirus crisis and what this means for portfolio construction going forward.
Revisiting Bleak Bonds
The paper originally made the following key points:
- Treasuries: Following the Global Financial Crisis (GFC) of 2007-09, monetary policy was kept too loose for too long. Yields were suppressed, punishing savers and bond holders.
- Corporates: Low borrowing costs encouraged companies to leverage up their balance sheets. Credit quality in corporate bonds has been deteriorating and a worrisome bulge of issues are rated BBB, just one notch above “junk” status.
- High Yield & CLOs: The chase for yield lead to easy funding for non-investment grade issuers. Lending standards were loosened, and the complexity of Collateralized Loan Obligations (CLO) drew worrying comparisons to mortgage backed securities (MBS) at the root of the GFC.
- Fiscal Outlook: As the baby boomer generation enters retirement, the fiscal situation of the United States is made worse by the “three D’s”: deficits, debt, and demographics. The country already spends more than it receives in revenues, and these trends are set to get much worse in the coming decade.
The Impact of COVID-19 on the Bond Markets
The COVID-19 pandemic has made the outlook for all these factors worse. If there was a doomsday clock predicting an eventual debt reckoning, the global pandemic moved the clock’s hands significantly closer to midnight.
As the coronavirus crisis broke out of China and swept across the globe, the impact on the financial markets and the world economy was severe.
In the U.S. the longest economic expansion and second-longest bull market came crashing to a halt. The S&P 500 lost over a third of its value in just over a month. Economies were locked down and millions thrown out of work.
Such an extreme shock to both supply and demand triggered a massive monetary and fiscal response, unlike any seen in history.
How Government Response made a Bleak Outlook Worse
If the intent of the stimulus was to buoy the equity market, the efforts were a success as the major U.S. market indices have recovered the majority of their losses.
However, the adverse impact on the bond markets was extreme.
Rates were pushed as low as they could go without turning negative. And yields along the curve are lower than they were during the Global Financial Crisis. Moreover, the Fed went big with Quantitative Easing, adding over $3 trillion in record time. If Treasury yields were paltry before, they are close non-existent now.
The compensation for holding Treasury bonds is essentially nil, forcing investors into riskier assets if they don’t want their portfolios invested in “dead money.”
In the initial stages of the sell-off a liquidity shock hit the investment grade market and bid/ask spreads exploded. This liquidity shock was not a surprise as dealers had reduced their bond inventories by 90% since the GFC. Once again, the Fed charged in to the rescue, first purchasing bond ETFs and then individual corporate issues.
While the liquidity issues have been resolved, credit concerns have moved to the front burner as the recession will take its toll on issuers across the economy. The fact that roughly half of the investment grade market is BBB rated is a big concern. Should these issues get downgraded, forced selling will likely occur due to many investors having restrictions on holding “junk” bonds. Meanwhile, with Treasury rates falling the absolute yield on investment grade corporates is lower than it was a year ago.
High Yield & CLOs
Concern is greatest in the lower tiers of the credit ladder. Investors at the low-end of the credit spectrum should brace for capital losses. Overleveraged firms always have cash flow problems during recessions, and this downturn was sudden and intense.
Some analysts are forecasting a third of CLOs will have problems meeting scheduled payouts. While many other asset classes have seen prices recover off of March lows, CLOs and portions of the high yield market are still languishing. Understandably, there has been a reluctance to dedicate public money to purchasing such low-quality debt.
The disconnect between the market and the economy has been a topic of much discussion. Unemployment is at levels not seen since the Great Depression and the economy is in a recession, yet the market has staged a historic rally. Even if a vaccine for the coronavirus miraculously appeared tomorrow, the bill for the coronavirus will be measured in the trillions.
Prior to the crises federal, state and local governments spent far more than their revenues, requiring massive borrowing in order to make up the difference. The response to the pandemic has accelerated these trends.
The federal budget deficit for 2020 is an estimated $3.7trn while state and local governments are under immense strain. The CBO estimates the federal debt has exceeded the nation’s annual GDP.
Bonds are Dead Money Going Forward
The outlook for bonds is looking dire, pushing advisors to look beyond traditional allocation for risk management, returns, and income. For decades the standard shorthand for a balanced portfolio was the 60% equity/40% bond model. Conventional wisdom was that the most conservative investors should have most, if not all, of their assets in bonds/fixed income.
But based upon the facts outlined above, advisors and investors should anticipate a world where bonds increase portfolio risk, rather than mitigate risk.
Allocating a significant portion of one’s portfolio to assets that are unlikely to produce a positive real return is a fool’s errand. Advisors must seek out better ways to mitigate downside risk in their clients portfolios.
The Time Is Now for Hedged Equity
Our outlook for bonds remains bleak and the time is now for advisors to seek out alternative solutions for managing risk and addressing income needs.
Our philosophy has always been to remain “Always Invested, Always Hedged.” We have been actively managing risk since 1997, and we do it without any bonds. Through a variety of solutions, we seek to actively hedge our market exposure via the use of put options.
Hedging has served us well through previous market downturns, and we believe it will continue to do so in future bear markets.