Duration Is Required
Duration Is Required
Bond yields are falling, what does this mean for the balanced portfolio?
March is proving to be a very difficult month for the financial markets. No, we will not discuss the collapse of Silicon Valley Bank (SVB) or comment on the company’s approach to risk management. After all, I’m just a technician with a top-down approach to markets. Pretending to be a bank analyst or money-market specialist isn’t on today’s agenda. With that being said, Axios did a fantastic job covering the fall of SVB. You can check out their suite of content here.
Last year, many portfolio managers noted the asymmetric risk to the downside in bond funds. If the Fed were to begin even a mild rate hiking cycle, the responding decline in bond prices would greatly weigh on investor returns. Market participants sought the safety of short-term bonds and alternatives to lower their portfolio’s sensitivity to interest rate fluctuations. Fast forward to 2023, the Fed moved forward with it’s most aggressive rate hiking cycle in history and the risk of recession is now as high as it’s been in the last 10+ years.
Retirees may be asking, “What does this mean for the balanced 60/40 portfolio?“
No matter the environment, intermediate and/or long-term bonds deserve a roster spot in the balanced portfolio. Yes, longer duration means an increased sensitivity to interest rates. However, when things get uncomfortable, whether it be due to declining investor confidence, liquidity, or moral hazard - history tells us that investors flock to the protection of US government and/or comparable investment grade bonds. Just take a look below at the month-to-date returns of the Aggregate Bond Index and Long-term Treasury Bonds. The asset class responded in a big way to turmoil in the financials sector.
If you’re investing in bond funds, this means substantial price appreciation in the event interest rates decline. We shared the below graphic several times and noted the attractive risk/reward back in July of last year. The message is very clear - adding duration (interest rate risk) continues to be top of mind for bond fund managers. Not only is the risk-reward attractive again, but investors were reminded earlier this month that treasuries rally in the wake of recession fears.
For a balanced portfolio, properly managing duration risk both to the upside and downside, is monumentally important. We believe this is best accomplished by selecting both an index-based bond fund and hiring an active bond fund manager. Active share in fixed income continues to attract investor interest. Just take a look at the below data from Fidelity. After 10-years, 90% of active funds in the intermediate core-plus bond category outperform their benchmark after expenses.
The 10-year US Treasury Yield remains in an uptrend, but is trading a hair beneath the 50-week moving average. Momentum as measured by the relative strength index or the price momentum oscillator, remains in a bullish regime. Price is yet to confirm a true breakdown in benchmark yields. However, market rate expectations have changed drastically this month.
For the first time this cycle, the market is signaling that the Fed is finished. The expected terminal rate (blue line) is now below the current Fed Funds Target Rate (orange line). To couple this, the probability of a 25 basis point hike at the May FOMC meeting declined to less than 15% and June’s FOMC meeting target rate probabilities are displaying nearly a 50% chance of a rate CUT!
Increased probability of rate cuts in 2023, recession probability at historic highs, evident stress in the US financial system…and you’re still considering whether or not to add duration to your fixed income sleeve? This isn’t a recommendation to go out and buy Long Treasuries - but in this environment, duration equals protection and for a balanced portfolio, it is required.
That’s enough out of me!
SM
Great read