In the recent past, investors satisfied both income and safety objectives with passive fixed income vehicles. Fast forward to today and investors are forced to navigate a challenging ‘bond maze’:
- Government policies creating an overabundance of false liquidity
- Negative yielding treasuries
- Deteriorating credit quality
- Inferiority of passive strategies
- Potential for loss of principal due to the imminent rise in yields
There is a misconception that these challenges require investors to take on more risk to satisfy their investment objectives. With the right professional manager, an actively managed fixed income strategy can help clients achieve their goals while limiting risk exposure.
Awash in Government Debt
The amount of government debt has increased substantially around the world — and there is limited political will to rein it in:
…budget deficits are only increasing…
Eventually higher deficits, and higher interest rates to fund deficits, will create more risks in markets.
Federal Reserve: Supercharged money printer
The Federal Reserve has several tools to keep interest rates low and push money (liquidity) into the financial markets. But since the financial crisis of 2008, the Federal Reserve greatly increased their intervention in the financial markets. Known as “quantitative easing” (QE), the Fed injects money into the financial markets to stabilize market wide selloffs.
Since the start of Covid-19 lockdowns in March 2020, the Federal money printer has been humming non-stop:
…Fed policy has been mirrored by other central banks…
Low (and negative) yields
Quantitative easing and lower interest rates — set by the Fed and other central banks — has led to all-time lows for government bond yields:
If you invested $1,000,000 into the US 10YR Treasury yielding 4.42% in 1998, you would receive $44,200 annually before taxes and inflation, today that same investment yields around $13,290 (depending on the day).
When you consider inflation and taxes, the real yield is negative. For investors, this means that after inflation you are actually paying the government when owning their bonds.
Deteriorating credit quality
As yields move lower, this drives investors into riskier fixed income securities (and riskier investments in general) to derive the same yield for investment goals.
To find yield, investors are forced to buy lower quality bonds at higher yields (more risk). It is important to note that in times past when the fed drives down rates, the results have not been satisfactory for the investor.
The above chart illustrates the rates on high yield CCC-graded bonds, which are considered ‘Junk.’ As rates on safer fixed income investments trend lower, investors move into lower quality investments. Therefore, yields on Junk have followed suit, with those rates falling to historic lows. Each of the upward spikes in the above chart were associated with 5-20% losses in positions that are supposed to be the ‘safety net’ of a well-balanced portfolio.
One of the key components of interest rate levels is inflation. As the Federal Reserve and US Government prints trillions of new dollars, prices for goods have spiked. If inflation continues at current levels, fixed income yields will also rise. This will also contribute to loss potential in the fixed income portion of portfolios.
Inferiority of passive strategies
In a fixed income environment where the quality of your portfolio matters most, market cap weighted passive funds like ETFs can incorporate a lot of bad investments. In market-cap weighted equity funds, the most successful companies (in terms of their market value) become the most heavily weighted. But in market-cap weighted fixed income funds, the most heavily weighted entities are those that have issued the most debt.
Moreover, fixed income funds can include sovereign governments, states and municipalities like Argentina, Venezuela, and Eurozone negative yield leaving passive investors with lower quality holdings.
These trends present a challenge for investors: How can you generate enough yield to satisfy your income needs at an appropriate level of risk?
Solution: Active Management
Experienced investment advisors with dedicated resources and expertise can curate individual fixed income securities to add value without altering risk profiles. Like active managers, passive managers can provide diversification. Unlike active management, passive vehicles contain unappealing bonds and are restricted in their ability to take advantage of opportunities.
jhh offers active fixed income portfolios managed by experienced investment professionals. Through thorough research and knowledge of the markets, investors are provided opportunities to generate returns more than passive portfolios. Given the challenges of the current market environment and uncertainty for the future, it’s critical now more than ever to allocate holdings to an active management strategy.
Advisory services offered through jhh wealth, llc, a SEC registered investment advisory firm and Colarion Partners, LLC, an Alabama state registered investment advisory firm. This information is not intended as and does not constitute an offer to sell securities or a solicitation of an offer to purchase any security or investment product. To the extent that this material concerns tax matters, each taxpayer should seek independent advice from a tax professional based on his or her individual circumstances. These materials are provided for general information and educational purposes based upon publicly available information from sources believed to be reliable — we cannot assure the accuracy or completeness of these materials. The information in these materials may change at any time and without notice.