While hardly as severe as the recent high yield bonds selloff that led to the closing of the popular Third Avenue high yield fund, the fallout from weaker global economic growth and cratering energy prices is spilling into high-grade corporate debt markets. Tossed into renewed market turbulence is the Fed’s long-awaited decision to start hiking short-term interest rates. With this combination of conditions, some advisors are shying away from recommending either junk or investment-grade corporate bonds.
Since May, the index-tracking iShares iBoxx Investment Grade Corporate Bond ETF has lost more than 2%, according to Morningstar. A passively-managed proxy for U.S. Treasuries, the Vanguard Intermediate-Term Government Bond ETF, had returned 0.25% through last week.
Admittedly, such market volatility represents a very small sample set. But to advisors who use bonds chiefly as a safe harbor for clients with equities-heavy portfolios, a confluence of market events is the latest evidence that Treasuries need to command most -- if not all -- of a typical client’s longer-term allocation to fixed-income.
“More than ever, investors need to avoid credit risk and stay firmly rooted in boring old government bonds,” says Charles Blankley, chief investment officer at Walnut Creek, Calif.-based Gemmer Asset Management, which manages about $850 million for other advisors.
Of course, since corporate bonds are less credit-worthy than federally backed Treasuries, they can usually be counted on to pay plumper yields over longer periods. At the end of last week, that spread was running about 1.65%, says Anthony Valeri, a fixed-income strategist at LPL Financial. His team helps run about $20 billion in managed-account assets for advisors. In new research, Valeri observes that the gap has grown “significantly” recently, compared to historical benchmark averages between the two bond classes.
Wider spreads might mean more attractive valuations for corporates. But it also indicates that even higher-rated corporate debt has been generally underperforming government bonds since spring, notes Valeri. Whether that trend holds up much longer is anybody’s guess, he adds. However, instead of trying to time market cycles, his belief is that advisors should stick to a client’s long-term investment plan.
“We’re recommending to our advisors that at least 50% of a client’s strategic bond allocation should be invested in government securities,” he says. “That’s a good starting point for most people, then you can adjust up or down by each person’s specific appetite for risk.”
At Gemmer Asset Management, Blankley is adamant about keeping at least 70% of his clients’ long-term allocations in Treasuries and agency mortgage-backed securities. If interest rates become too problematic, he plans to “simply smooth out any volatility curves” by managing bond portfolio durations -- a measure of interest rate sensitivity.
Gregg Fisher, chief investment officer at Gerstein Fisher in New York, argues that most people should confine exposure to market risk by owning more stocks. Advisors at his firm, which manages about $3 billion, usually steer clients with 60% in stocks to put the remaining 40% into investment-grade government bonds. Those might include Treasuries, agency mortgage backed securities and high-rated municipals. “If clients want to take on more riskier credits, our response would be to not bother -- it’d be a much better tradeoff to increase their equity allocations,” says Fisher.
In fact, new research by Gerstein Fisher estimates that domestic intermediate-term investment-grade corporates over the past 29 years produced 4.1% in standard deviation, a measure of market volatility. By comparison, similarly termed Treasuries generated 25% less. At the same time, the firm’s analysts figure those high-grade corporates only provided about 1% more in average annual returns.
Also worth noting in the study: The S&P 500 index returned about four percentage points more annually on average than intermediate investment-grade corporates. “So despite taking part in one of the strongest bull markets for bonds in history,” says Fisher, “investors really weren’t paid very well for the increased risk they assumed by owning investment-grade corporates.”
Jared Kizer, chief investment officer for Buckingham Asset Management, likes to keep 100% of most clients’ bond sleeves in government-related securities. Admittedly, some of the bond mutual funds included in portfolios overseen by the firm do own small amounts of higher-grade corporates. “But we’re not allocating anything directly into non-government related bonds,” he says.
Advisors at the St. Louis-based firm, which manages about $7 billion and runs the BAM Alliance supporting a national network of independent RIAs, admit conversations can be sticky with clients who are resistant to loading up on super-safe fare when inflation and interest rates are still hovering at historically low levels. Kizer counters such questions by showing more aggressive investors data his firm has developed indicating that $1 of investment-grade corporates carries about the same market risk as owning 90 cents of Treasuries and 10 cents of stocks.
For example, he finds it’s not unusual for some clients to initially ask about putting 100% of their bond allocations into corporates. Using such a thumbnail statistical sketch, Kizer says he can show that in a 60/40 portfolio, a 5% increase in stocks along with a full conversion to government-related bonds can provide more security without limiting potential gains.
“It’s important to show people how we can make some simple, well-defined tweaks to lower their exposure to credit risk -- without sacrificing any potential long-term upside,” says Kizer. “It’s a formula that we don’t see used often enough, in good times and bad.”