Why Diversifying with Bonds Still Makes Sense

The recent market downdraft experienced in the high-quality fixed income space may have some questioning the diversification benefits of holding bonds. Typically, high-quality bonds and equities are negatively correlated, meaning bonds can offset losses in equities by rising in value when stocks fall. The negative correlation is due in part to the fundamentally different risks associated with each asset type. The cash flows associated with high-quality fixed income instruments backed by the federal or local governmental bodies such as Treasurys, agencies and municipal bonds (investment-grade specifically) are rarely if ever impaired. These securities are primarily affected by interest rate changes (basically a change in the discount rate). This rate risk also impacts equities, and high-yield bonds (debt issued by companies with lower credit ratings), however, along with that comes a much more significant amount of credit risk. In simple terms, credit risk is the risk that future cash flows are impaired, whether those cash flows are in the form of corporate earnings or the coupon payments of high-yield bonds.

This is why a recession tends to cause a correction in the equity market as well as the high-yield bond market. For high-quality fixed income, the impact is often the opposite, the economic contraction causes interest rates to decline as inflationary pressures ease and results in bond prices rising. Despite recent moves in which stocks and bonds lost value together, this basic financial premise has not changed.

Opportunity in volatility

A Fed tightening cycle along with the volatility it creates can result in multiple opportunities to improve the risk characteristics of your overall portfolio, as well as position for future profit opportunities. In many cases, the fixed income market provides opportunities to reduce risk without much of a reduction in the long-term return expectation of a portfolio. Intermediate bonds (those that generally have a duration of four to six years) have typically offered the most appealing balance of risk and return over the long term. The maturity of specific bonds can vary due to their structures. For example, some are non-callable (meaning the issuer can repay the debt before the stated maturity of the bond) while others may be issued at higher coupon rates in exchange for the issuer being able to retire the debt before the stated maturity date. Additionally, laddered portfolios can hold bonds with varying lengths of term such as 1 to 15-year municipal bonds or 1 to 12-year taxable bonds.

From Jan. 30, 1976, to March 31, 2022, the Intermediate Bloomberg Barclays Aggregate Index (Intermediate) returned 6.67 percent annualized while the Bloomberg Barclays Aggregate Index — which has a longer duration — returned 6.89 percent. What makes this interesting is that the Intermediate returned 96.8 percent of the annualized return of the Aggregate while having much lower volatility or risk. The data on both index’s characteristics is unavailable back to 1976, but if you look at the period of Dec. 31, 1999, to March 31, 2022, the duration of the Intermediate was only 73 percent of the Aggregate Index. During this period the Intermediate index returned 91.3 percent of the Aggregate Index’s return. Reducing the duration risk by more than 25 percent while only giving up 9 percent of the return is an attractive proposition. A portfolio that has a slightly lower return while offering a significant reduction of risk may allow you to allocate that risk elsewhere where you are better compensated. Also, it allows flexibility to add duration risk or credit risk during a period of market dislocation.

Capitalizing against the current backdrop

So where are the opportunities currently? One of the more specific recommendations that jumps out given our recent analysis of Treasury bills and 2-year notes. The 2-year notes offer an attractive option to take some risk off the table as compared to holding cash. There is so much Fed tightening priced into the 2-year that we’d expect it to outperform cash in all but the most extreme scenarios.

Individual investors dominate the municipal space. As a result, negative sounding headlines tend to have a disproportionate impact on the municipal market. For much of 2022, investors have been pulling significant assets out of municipal bond funds which has caused managers to sell bonds. This has caused 10-year municipal bonds to trade as high as 104 percent of the value of comparable Treasury bonds. The fact that investors can buy municipal bonds at the same yield as a taxable Treasury bond is rare and is unlikely to remain that way for long.

Finally, there is an increasing risk that Fed tightening will impact the credit market to a much larger extent than we’ve seen so far. Much of the underperformance of financial assets (whether they are equities or corporate bonds, Treasuries, etc.) has been in response to a rise in discount rates. If the rise in interest rates lead to a recession and the impairment of corporate cash flows, credit spreads can be expected to rise much more significantly than the market has experienced recently. Spreads have widened but can widen much more if the likelihood of a recession increases. The U.S. Corporate BBB/Baa spread, which measures the difference between the lowest level of high-quality bonds and Treasurys with same duration to maturity has widened to approximately 198 basis points from 104 basis points since late last year, but any risk of recession can cause this spread to widen significantly. Spreads in the corporate high-yield market (currently at 480 basis points to Treasurys) would likely see even more widening than we would expect in BBB corporate bonds in a recession.

Conclusion

A Fed tightening cycle can provide multiple opportunities to improve the risk characteristics of your overall portfolio, as well as position for future profit opportunities. As always, it is helpful to think of the above recommendations as “tilts,” not all or nothing propositions. Markets can be quite volatile as the Fed tightens, so use the volatility to your advantage. It is more prudent to incrementally add 2-year Treasury exposure or 10-year municipal bonds (as an example) incrementally and adjust as conditions warrant.

Northwestern Mutual is the marketing name for The Northwestern Mutual Life Insurance Company, Milwaukee, WI (NM) and its subsidiaries. Investment brokerage services are offered through Northwestern Mutual Investment Services, LLC (NMIS) a subsidiary of NM, broker-dealer, registered investment adviser, and member FINRA and SIPC. Investment advisory and trust services are offered through Northwestern Mutual Wealth Management Company® (NMWMC), Milwaukee, WI, a subsidiary of NM and a federal savings bank. The opinions expressed are those of Northwestern Mutual as of the date stated on this material and are subject to change. There is no guarantee that the forecasts made will come to pass. This material does not constitute investment advice and is not intended as an endorsement of any investment or security. Information and opinions are derived from proprietary and non-proprietary sources. You should carefully consider risks with fixed income securities such as bonds, these include: Interest rate, Duration, Credit, Default, Liquidity and Inflation. Interest rates and bond prices tend to move in opposite directions, for example when interest rates fall, bond prices typically rise. This also holds true for bond mutual funds. A low interest rate environment may cause losses to bond prices and bond funds you own or in the market. Interest rates in the United States are at, or near historic lows, which may increase a Fund’s exposure to risks associated with rising rates. High yield (Junk) bonds and bond funds that invest in high yield bonds present greater credit risk than investment grade bonds. Please remember that all investments carry some level of risk, including the potential loss of principal invested. Indexes and/or benchmarks are unmanaged and cannot be invested in directly. Returns represent past performance, are not a guarantee of future performance and are not indicative of any specific investment. Diversification and strategic asset allocation do not assure profit or protect against loss. All index references and performance calculations are based on information provided through Bloomberg. Bloomberg is a provider of real‐time and archived financial and market data, pricing, trading, analytics and news