Investors often ask us which of the two main bond market risks they should focus on—interest rate or credit. Our answer? Both—and the way they interact with each other.
Most investors know they need to take both risks if they want to generate more income and diversify their stock exposure. But in today’s bond market, it’s more important than ever to get a handle on how to manage interest-rate and credit risk in an integrated way.
Investors typically view interest-rate–sensitive bonds (global government bonds, inflation-linked bonds) and growth-sensitive credit assets (high-yield corporate bonds, bank loans, emerging-market debt) as two separate groups. And they use different managers for each.
In theory, the divide-and-conquer approach works like this: if the assets in the credit-oriented portfolio get too expensive to justify the risk, a manager might sell some of them and shift those assets into the rate-sensitive portfolio.
But there’s a problem with this approach. Managing these pools of assets separately can cause investors to miss income-generating opportunities and take on too much exposure to the risk of losses.
THE PROBLEM WITH DIVIDE AND CONQUER
It’s not easy to shift money quickly from one portfolio to another. For one thing, nobody who manages assets for a living has a crystal ball. It’s hard to forecast interest-rate changes or credit events. Anyone can get lucky once or twice. But even the most seasoned investor struggle to get it right consistently.
Even if crystal balls did exist, they probably wouldn’t do bond investors much good, because credit markets—especially high-yield bonds—are relatively illiquid. With about 5,000 global credit issuers and a dizzying array of securities, it can be a major challenge to buy or sell a specific bond or block of bonds.
Some investors may try to address this hurdle by putting their bonds on autopilot—and taking active managers out of the equation. But that’s not much of a solution. Strategies that passively track a market index can’t pick and choose their exposures at all—they’re locked into exposures just because those issuers are part of the index.
What’s more, most passive managers don’t even try to own every security in the index. They compensate by buying more of the biggest ones. This should worry investors, because bond issuers with the biggest weights in indices are countries or companies that issue the most debt. If any of these issuers run into trouble, there’s no way passive investors can limit their exposure.
Finally—and maybe most importantly—investors who manage interest-rate and credit risk separately, whether in active or passive strategies, may overlook the crucial interplay between the two.
This is something market participants haven’t had to think much about over the last decade. Interest rates plunged after the global financial crisis, inflation evaporated and central bank policy—not the real economy—became the most important variable for global bond markets. For years, investors could almost ignore interest-rate risk. At the same time, central banks’ easy money policies made companies less likely to default, leaving investors free to load up on credit risk to boost returns.
WITH BONDS, COMBINE AND CONQUER IS BETTER
But the long bull market for bonds was the exception that proves the rule. More recently, the macroeconomic sands around the world have started to shift. The global economy is gaining traction, and interest rates have started to rise.
The US Federal Reserve began lifting borrowing costs in 2015 and may soon sell some of the US Treasuries and mortgage-backed bonds it acquired during the crisis. If the world economy strengthens further and inflation rises, the European Central Bank and Bank of Japan may soon follow suit. How the three go about shrinking balance sheets totaling nearly US$13 trillion could have major implications for market stability (Display 1).
Governments, meanwhile, are moving toward more expansionary fiscal policies, which could stoke inflation, especially in economies at or near full employment. At the same time, many corporate bond valuations are stretched, and credit cycles are diverging across sectors and regions, with some nearing the end of a multiyear expansion.
In other words, investors today must pay constant attention to interest-rate and credit risk. That means having a manager who understands how the two interact and has the flexibility to tilt toward one or the other, depending on rapidly changing conditions.
Doing this effectively calls for a “combine-and-conquer” approach: pairing the two groups of assets in a single strategy known as a credit barbell and letting managers adjust the balance as conditions and valuations change.
When managed effectively, this strategy may minimize large drawdowns while still providing a strong and steady stream of income. For investors, that can mean more efficient income.
In this paper, we’ll take a look at how investors can build a barbell and how it stacks up against other fixed-income strategies. But there are a couple of things to keep in mind:
We use US Treasuries throughout to represent interest-rate– sensitive assets and US high-yield bonds as a proxy for growth assets. As the appendix tables on pages 10 and 11 show, performance results are similar when using global high yield, though they rely on a slightly shorter data set.
In practice, of course, investors will want to own a broader array of rate-related and growth-sensitive assets from a variety of sectors, industries and regions.
THE ASSET-ALLOCATION SEESAW: HOW TO FIND BALANCE
When building a portfolio, it helps to visualize your investment options as an asset-allocation seesaw, with cash in the middle, government bonds on the left and return-seeking assets such as high-yield bonds or equities on the right (Display 2).
The assets on each side of the seesaw tend to react differently to most macroeconomic factors. The reason they behave as they do is connected to their dominant risk premiums. Just as each person represents a unique combination of genetic building blocks, each fixed-income asset class carries a unique combination of premiums for various kinds of risk.
Interest-rate–sensitive assets such as US Treasuries or German Bunds have two main risk premiums. The real-interest-rate risk premium is the portion of the coupon that compensates investors for lending money to the government, while the inflation-protection risk premium protects the purchasing power of a bond’s principal.
Corporate bond yields consist of the yield on comparable-maturity government bonds plus a credit spread, which can be broken down into further risk premiums. So in addition to the two mentioned above, corporate bonds carry a credit, or default, risk premium, the portion of the spread that compensates for the possibility that the issuer will suffer a credit downgrade, become unable to make coupon payments or go bankrupt.
For example, faster growth tends to feed inflation, which erodes the purchasing power—and market value—of government bonds. But it can boost consumer spending and corporate profits—good news for high-yield bonds because it lowers the odds of default.
Investors get paid to take both types of risk. US Treasuries offer a premium over cash, while high-yield bonds offer an additional premium over US Treasuries (Display 3). The returns on all three assets will vary over time, but the premium you’re paid for taking additional risk remains.