Fixed‐income investors are making some false assumptions about the market that could negatively affect portfolios, according to Co‐Chief Investment Strategists Emily R. Roland, CIMA, and Matthew D. Miskin, CFA. Using fixed‐income data analytics and market history, the strategists debunk narratives such as the U.S. Federal Reserve tapering its bond purchases will automatically lead to higher U.S. Treasury yields. Listen to this podcast to avoid four fixed‐income myths in today’s markets.
John Bryson:
Hello, and welcome to the Portfolio Intelligence podcast. I’m your host, John Bryson, head of investment consulting and education savings at John Hancock Investment Management. Today is September 16,
2021, and I’m joined by Emily Roland and Matt Miskin, our co‐chief investment strategist at John Hancock Investment Management. As you may know, Matt and Emily are the architects behind our quarterly capital markets outlook piece titled Market Intelligence. Matt and Emily also gave me a sneak peek at a new blog they’re working on where they discuss four myths facing fixed‐income investors today. Hey Matt, why don’t you jump in and tell us why you put this piece together in the first place.
Matt Miskin:
Thanks for having us, John. We’re really excited about this piece, and really this is us going through some of the data and really fact‐checking some of the prevailing assumptions in the fixed‐income market, and making sure that these risks that we’re hearing in the fixed‐income markets really show up in historical data. And Market Intelligence, as we all know, is kind of where we stress test things, where we’re looking at the fixed‐income risks out there and thinking about positioning. But in this blog, we’ve got four major, what we believe, are misconceptions or myths around the fixed‐income markets.
Matt Miskin:
So the first one, in essence, is that the Federal Reserve raises rates in midcycle environments and that you want to be in short duration. So midcycle is the part of the cycle we believe we’re in. But what we found was that actually the makeup of performance is a bit different, and the leaders in laggards in midcycle investing in fixed income, aren’t as intuitive as you might think.
Matt Miskin:
Another one is that the Federal Reserve is likely to taper quantitative easing, and the thought would be that Treasury yields would rise as the Fed buys less bonds. Counterintuitively, we found actually that that hasn’t been the case in the last times that they have done tapering, so we’ll talk about that.
Matt Miskin:
Another one: Investors should look for the equity market to provide yield or income given that the bond market is providing so little yield. We have some kind of differentiated views on that and some thoughts, risks that should be considered for that kind of move.
Matt Miskin:
And then the final one is that greater supply results in higher Treasury yields. So we all know that government is issuing more Treasury debt to fund the stimulus from the pandemic. But counterintuitively, in fact, more often than not, yields don’t rise on greater supply, and we could talk about some of those details. So a lot to cover, but we think that this is very helpful for setting the stage as a fixed‐income investor and what is becoming an increasingly challenging environment in terms of bond investing more broadly.
John Bryson:
And it's certainly timely, because these are all challenges we’re hearing about in the marketplace and I’m sure you are too. So, Emily, I want to pull you into the conversation. One of the myths that Matt had mentioned, let’s start with this one. It’s about shortening the duration; it’s been a popular move on and off over the last few years or if not longer. Why are you advising against it right now? Let’s dig in a little bit deeper.
Emily Roland:
Thanks, John, for having us today. And I first want to apologize for a couple dings that you heard there. I made the rookie mistake of leaving my email open on our podcast today. So still learning lessons here even 18 months into working remotely, so apologies for that.
Emily Roland:
You know, I think this is one of the biggest kind of misconceptions out there around the Fed raising rates. You want to be shorter duration, and it’s actually something that we typically hear after recessionary period. So the idea is that when you are in this sort of early to midcycle environment, or the first couple of phases after the recession, the 10‐year Treasury yield is going to rise as the economy improves, as inflation picks up. But when we look more closely at the data, yes, there is an initial backup in yields right after the recession, but it’s actually pretty short‐lived. And the peak in the 10‐year Treasury actually occurs right after the recession. We looked at that over the last 40 years—four different economic cycles—and we found that the 10‐year Treasury actually did find its highest level of the cycle within a year. After the recession and it peaks and then it fluctuates in a trading range, and then it ultimately finds a new lower low in the next recession. And this has had a huge impact on the relative performance that we’ve seen across different parts of the fixed‐income market.
Emily Roland:
So one thing we do in this paper is look at, and previous work that we’ve done, is look at Morningstar category returns over those, the last two cycles. And what we found is that short duration strategies, which frankly have attracted a ton of assets, have actually been the worst relative performers in midcycle periods. The best performers, meanwhile, have been corporate bonds, including high yield.
Emily Roland:
And the logic here is that the shorter duration strategy, the forecasts are going to offer lower income potential, given the low‐rate environment, while corporate bonds actually don’t see as much of a duration headwind as investors expect, because again, longer dated Treasury bond yields actually end up staying more anchored than expected. So instead investors are going to be able to benefit from that greater income potential you’re going to get being further out on the curve.
Emily Roland:
So bottom line is that overemphasizing short duration strategies and fixed‐income portfolios, you may leave returns on the table doing that. We suggest instead looking to corporate credit, earning that greater income potential for this middle part of the cycle, looking at intermediate term and really positioning for this midcycle environment that could last for some time here.
John Bryson:
No doubt. That's excellent advice. It takes this focus away from the short term and over to medium and long term where you’re really going to get some value for the investments that you have.
John Bryson:
So, Matt, I want to come back to you. The second myth that you and Emily challenged is that when the Fed starts tapering bond purchases, the yield on long‐dated Treasuries, they're going to rise. That seems logical, that thesis that when demand dries up yield should rise. So what are people missing?
Matt Miskin:
So this is going to be a big development into 2022. The Fed has really forecasts that are foretold, that they’re going to be tapering quantitative easing. Now they’ve done this before so we’ve got some history here. Quantitative easing is a relatively new phenomenon and it really started last cycle. But in 2010, 2011, they stopped QE2. So they basically halted the balance sheet growth right in after QE2, and that was in just about 2011. But oddly enough, what happened to the 10‐year Treasury yield? It actually went from about 3% and then it fell over the next several years and troughed around 1.5%. So counterintuitively in that example, reduction of the balance sheet expansion caused the 10 year to actually fall. Then we have another example here in 2013. At the end of that year, the Fed actually tapered quantitative easing, and what happened? The 10‐year Treasury yield peaked at about 3%, and then over the next several years was basically in a down trend to about 1.5%.
Matt Miskin:
So the last two times the Fed has either stopped, increased their balance sheet, or tapered their balance sheet, both of those examples saw the 10‐year Treasury yield fall. So why is this? Well, when we look back at those periods, what we’re seeing is that the Federal Reserve had already done a lot and the economy had already come back. But when we look at the leading economic indicators, so just kind of a proxy of how good the economic data was coming in, we were seeing that the economic data was peaking and starting to decelerate, meaning the best growth rate was behind us, the Fed had done all the stimulus, but then we were transitioning to another part of the cycle, one of a slower growth environment.
Matt Miskin:
And when we have a slower growth environment, investors typically gravitate to higher‐quality investments, which usually results in a flatter Treasury curve, it means that the 10‐year Treasury yield and longer data yields get a bid, meaning there’s more demand for them. And so what we’re seeing is it’s not really as much about the tapering; it’s more about the cycle. And when we look at the leading economic indicators today, they peaked in April, they’re decelerating. Now they’re still at a high level, we’re not seeing a recession on the horizon at this point, but as the LEI decelerates, leading economic indicators decelerate, it usually means the Treasury curve flattens. It means there’s a bid, or demand, for longer dated Treasury yields. So we believe actually that this time could be very similar and that you may not see upside pressure on yields, even though the Fed is buying less as it relates to quantitative easing.
John Bryson:
So that’s more on the demand side. Let’s also talk a little of the supply side, because one of the myths you talk around in the paper is about supply and a larger deficit. Can you dig into that for our audience?
Matt Miskin:
So one of the largest fears that we hear every day, and it’s a logical one, is we’ve got a massive deficit in the United States, and we are increasing our supply of Treasury bonds every year. And last year was one of the largest ever; increase wise, we almost added a trillion dollars. We did nearly four trillion dollars of Treasury debt issued in 2020, and it’s on pace to be massive again this year. But when we look back, so the government has been issuing debt for a long time, turns out. This isn’t a new phenomenon. We go back about 15 years, they were doing $700 billion, now they’re doing $4 trillion. So there’s been a massive ramp up in Treasury issuance, the whole last cycle, past the global financial crisis, we’ve been issuing debt pretty consistently.
Matt Miskin:
And we look back, okay, so we’re looking for periods where issuance of Treasury bonds creates higher yields. And we just do not see the connection. There’s been years where there’s been a huge issuance. Last year was a great example: 2020, we did four trillion. What did the 10‐year Treasury yield do? It dropped 1%. So even though all this supply came online, yields actually fell. So why is this? The reason to us, I think this quote is the one to really think about, “Debt is a tax on future growth.” So we’re issuing all this debt, we’re managing our way out of this pandemic recession, but what it does is it creates this hindrance to growth because you’re not able to buy new things, you’re not able to invest in the future, you’re paying for the past. And as you pay that interest, even though that interest is low, it’s a weight on growth.
Matt Miskin:
And when you have a weight on growth, oddly enough, it’s almost like a circular feedback loop. Lower growth profile means lower interest rates. And you keep doing this. In Japan, it’s a perfect example. They have issued a ton of debt and they’re not seeing any inflation, in fact, they’re just seeing very low yields. So it’s another very counterintuitive part of the bond market that more supply actually creates lower yields. But the key linchpin there is that it really creates a lower global growth profile, in general, and then actually creates more demand for bonds. And that’s why, even though there's more debt outstanding, yields have been compressed amid this environment.
John Bryson:
It’s fascinating thinking through the chess versus checkers approach here. You got to think through multiple layers and plan ahead, so this is great insight.
John Bryson:
So Emily, I want to talk about the final myth in the blog. You discuss another phenomenon that we’ve seen a lot over the last decade. Investors using equities to boost their income. What’s yours and Matt’s take here?
Emily Roland:
This one intuitively seems to make a lot of sense. So we often hear from investors that because the yield on fixed‐income assets is so low that it’s better to go to equities for income, and it is true. The yield on the [Bloomberg U.S. Aggregate Bond Index] or Agg is now at historical lows, it’s around 1.4%. Clearly, that’s limiting income potential. And this could make—you’re looking at the dividend yields on the S&P 500—and it can look pretty attractive at times on a relative basis. But you’ve got to look a little closer under the hood. So right now, the dividend yield on the S&P 500 is 1.27%, and that’s actually a bit less than the yield on the Agg.
Emily Roland:
The other thing to remember here is equities come with more risk than bonds. So while that dividend yield may look attractive, you’ve also got to look at the volatility profile of equities as well. And when we look at the three‐year standard deviation of the S&P 500, it’s around 18%, while the standard deviation on the Agg is about 5.4%. So that’s something that’s important to consider. When you make that move from bonds to stocks, you’re going to increase the volatility profile of your portfolio.
Emily Roland:
Now don’t get us wrong. We still view equities as a really important part of a portfolio. You want equities for that capital appreciation element to reach your investing goals, but think of it, as bonds playing the other critical half of a portfolio. You want to generate those dependable returns, you want to provide that ballast in periods of equity market volatility. So something to think about in terms of that decision, looking a bit further at the data and just remembering across all four of these myths that these beliefs and experiences, and now it's exacerbated by all of the financial media and Twitter, so there’s so much information coming. I know it’s a lot of noise. If you're watching the media or looking at Twitter, of course, we want you to pay attention if Matt and I are being featured there, but otherwise not. No, I’m just kidding. But there’s a lot of information out there that’s not always grounded in data and analysis. So we think it’s important to rethink some of those narratives and make sure that we’re actually doing the work to understand if they've been true over time.
John Bryson:
That's excellent. And Emily, you and Matt are two of the few that I do pay attention to on Twitter, so I encourage that. And your point, and I’ve heard you say this before, have your bonds act like bonds in a
portfolio that’s critical. And I know that our investment consultant team’s been out talking for a long time about have your equity act like equity and not have it be too sensitive to interest fluctuations, or at least understand those. And that kind of ties into your point here. So I think that’s really timely and really great takeaways for this blog that you create, this white paper or viewpoint. So when is it coming out and how can people access it and any of the other material, Emily, that I know you and Matt are pumping out great material.
Emily Roland:
So, John, you can access our blog on the website, jhinvestments.com in the Viewpoint section. It’s pretty easy to find. A lot of these themes we also examine in Market Intelligence, which is our quarterly flagship outlook on the markets and economy, which you talked about at the beginning today. The new version of Market Intelligence will be out on or around October 7. You can also find that on jhinvestments.com. On the top‐right there is an opportunity to click on Market Intelligence. We also, John, have a Weekly Market Recap that may be of interest where we explore these issues. We think about what’s driving markets over the course of the week, we preview the week ahead, all sorts of great resources that we're producing, and we hope helps in advisors businesses today.
John Bryson:
I’m glad you mentioned all those pieces. I pay attention to them all. It helps me personally cut through the clutter. I’ll read a lot of the things that everybody else reads, but your material, yours and Matt’s material, helps me cut through the clutter and get to the heart of it.
John Bryson:
So Matt and Emily, you’ve been great guests. I’ll always love having you on. Thank you for sharing and giving us a sneak peek to this new insights that you’re going to be putting out there. Folks, if you want to hear more of our podcast, please subscribe to Portfolio Intelligence on iTunes, or like Emily mentioned, visit our website, jhinvestments.com. You can get up to speed on our podcast and all of the great stuff that Matt and Emily and the rest of our network is producing around the market portfolio of construction techniques, business building ideas and a heck of a lot more. Everybody, thanks for listening to the show. Have a great day.
Disclosure:
This podcast is being brought to you by John Hancock Investment Management Distributors LLC, member FINRA, SIPC. The views and opinions expressed in this podcast are those of the speaker, are subject to change as market and other conditions warrant and do not constitute investment advice or a recommendation regarding any specific product or security. There is no guarantee that any investment strategy discussed will be successful or achieve any particular level of results. Any economic or market performance information is historical and is not indicative of future results, and no forecasts are guaranteed. Investing involves risks, including the potential loss of principal.