How To Navigate A Fixed-Income Bear Market

Despite the recent brush with default, the credit risk of U.S. Treasury securities is extremely low, but be aware that Treasuries are not void of volatility.

The chart below shows the max drawdowns for a variety of fixed income indices during 2013.  Maximum drawdown is calculated as the percentage loss that an index or investment incurs from its peak net asset value to its lowest value.  The right column details the 3-year annualized performance for each index.

The recent volatility hit many investors like a ton of bricks.  The bond bull market that began in 1981 had lulled many fixed income investors into believing annual returns would always be high and downside risk would always be low.  Even industry professionals are being caught off guard and scrambling for solutions not only for their fixed income clients but also for their bond exposure within their clients’ asset allocation models.  Also, the “buy-and-hold” fixed income investors seem to be scratching their heads wondering how their yields will keep up with prevailing interest rates as they ratchet higher.  Let’s take a quick look at the various types of risk inherent in the fixed income markets, before we proceed further with some recommendations to help navigate this type of interest rate cycle.

Along with credit risk, bonds also face other risks.  Market risk,  or interest rate risk, is simply the risk of selling bonds prior to maturity at a price lower than they were initially purchased–or of locking in low yields and not benefiting from rising interest rates.  Event risk is the risk that bonds will drop in value due to unforeseen circumstances such as a tsunami, earthquake, war or global financial crisis.  Inflation risk is the risk that the purchasing power of your initial investment is worth less when it is sold.  Foreign exchange risk is essentially the currency risk of owning International bond ETFs that are invested in sovereign or foreign currencies.

I mention these risks because the best way to navigate a rising U.S. interest rate environment is to own a variety of low correlated fixed income instruments.  Each of these investments carry risks that are above and beyond the typical Treasury bond portfolio.  Although there are additional risks, I believe looking outside of traditional fixed income asset classes is essential to weathering a rising interest rate environment.  The chart below looks at a variety of bond asset classes and their correlations to one another.

Owning different fixed income asset classes can possibly smooth out the ride.  For instance, corporate bonds correlate to global fixed income 22% of the time.  This means there are times when global fixed income is going up while U.S. corporates are falling, and vice versa.

My firm currently owns the SPDR Barclay’s International Treasury Bond ETF (BWX), both as a currency as well as a yield play, because the underlying bonds are denominated in local currencies, not U.S. dollars.  Investors should only own this particular ETF when the dollar is stable or falling against the basket of currencies that make up the ETF.

The other international ETF that we have the ability to rotate into is the PowerShares Emerging Markets (PCY).  This is another currency and yield play, and there are added risks (foreign exchange risk, country specific risk, credit risk) that need to be considered, but emerging market debt exhibits a low correlation to other fixed income asset classes and can be a valuable component to smooth out returns during a rising U.S. interest rate cycle.  The yield is nearly 5%.

For U.S. high yield exposure we use SPDR Barclay’s High Yield Bond (JNK).  The correlation for U.S. high yield is negative compared to core fixed income, which makes it an ideal complement within a fixed income portfolio. At SGS , we rotate and overweight the two strongest relative strength ETFs out of the three listed, while also including the Vanguard Total Bond Market (BND) ETF, as well as the iShares TIPS Bond ETF (TIP), and cash.