BOND MARKET INSIGHTS

Investing without a parachute

Jeffrey Rosenberg |Jun 1, 2020

In the wake of the coronavirus crisis, the U.S. bond market finds itself flirting with negative interest rates and bumping up against the “zero lower bound”—calling into question the ability of bonds to provide ballast in future equity sell-offs. Are we at risk of investing without a parachute?

Bond market highlights

  • The coronavirus crisis pushed the Federal Reserve (Fed) to the zero lower bound of interest rates with promises not to reverse course anytime soon. With less room for rates to fall, traditional “bond ballast” likely provides less generous returns for the next downturn.
  • The upside to the recent crisis however is spreads provide some offset to the decline in interest rates. These wider spreads reflect heighted default uncertainty. Yet Fed liquidity support is limiting the impact in investment grade, fallen angel high yield bonds, and agency MBS—increasing the relative appeal of these fixed income sectors.
  • The recent performance of fixed income highlights the need for increased clarity on its role either as income or ballast. Higher income can be attained, but only at the cost of sacrificing safety.
  • The level of yields is not the only determinant of the efficacy of bond ballast—the initial conditions matter as well. Those have clearly changed as new monetary and fiscal coordination emerges in the coronavirus aftermath. Greater use of fiscal policy and willingness to engage in monetary financing—where central banks provide the money for increased government spending—alongside potential shifts in longstanding globalization trends all may upend historical assumptions underlying the negative correlation between stocks and bonds.
  • Alternative forms of diversification increase in importance in such an environment. We discuss “Defensive Alpha” strategies, and the structural underpinnings supporting their outlook as alternative diversifiers for equity risk.

Rethinking fixed income at the zero lower bound

Historically, investors have allocated to fixed income to meet any of three key objectives: capital appreciation, income generation, and preservation of principal. Fixed income’s typical ability to provide ballast against equity sell offs rests in the normal response of lower interest rates to falling stocks. However, in recent years, super low, zero and even negative interest rates have driven up the value of fixed income securities limiting further capital appreciation and calling into question the asset class’s ability to diversify against future equity drawdowns. 

At the same time, the coronavirus crisis is pushing the Fed to lower interest rates to zero for the second time in just over a decade. Now, policy makers are bumping up against the zero lower bound on interest rates—or theoretical lowest level that interest rates can fall to before they become unenticing to investors and ineffective as a way to stimulate economic growth.  While it is true that negative rates have been seen in other countries around the world before, the scope of negative rates is limited. Why? Interest rates cannot fall (much) below zero because if they do, investors have the option of holding cash which pays no interest, but that is better than a negative-yielding asset.

We believe in this historically unprecedented period; investors should be rethinking the role of fixed income in portfolio construction and ask themselves if they are at risk of investing without a parachute?

The answer requires a reexamination of the Global Financial Crisis and the last bout of zero interest rate policy.

From the fear of rising rates to the fear that rates can’t fall far enough

After the Global Financial Crisis, the fear was future increases in interest rates. Today, it is the fear interest rates won’t be able fall far enough to provide the safety investors expect from bonds.  

The below figure puts the discussion in its historical context. The average decline in the Fed’s policy rate during recessions averages nearly 400 bps – yet the cuts to zero in response to the coronavirus crisis amount to only 175 bps. For longer maturities, the 10-year interest rate on average falls over 300 bps during recessions. Coming into the coronavirus crisis, the 10-year Treasury stood at around 1.75% and has fallen around 100bps. And unlike during the Global Financial Crisis, further declines in longer term interest rates are clearly more limited. Today the 30-year Treasury yield stands just under 1.4% in contrast to close to 5% in the leadup to the Global Financial Crisis.

Ultra-low rates leave less room for future Fed cuts
U.S. policy and 10-year interest rates during recessions.

Ultra-low rates leave less room for future Fed cuts

*10-year Treasury change reflects the biggest move seen from as early as 6 months before the recession period.
Source: Bloomberg, as of 5/22/2020

This implies simply less room for rates to fall when the Fed needs to again provide future accommodation. With zero as the effective lower bound, potential rate declines from here stand clearly lower than in past recessionary periods, implying less potential for positive fixed income returns to offset negative equity returns.

In such an environment, alternative forms of ballast take on even greater importance.

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Jeffrey Rosenberg
Jeffrey Rosenberg
Sr. Portfolio Manager, Systematic Fixed Income
Jeffrey Rosenberg, CFA, Managing Director, leads active and factor investments for mutual funds, institutional portfolios and ETFs within BlackRock's Systematic Fixed ...
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