Many investors have been brainwashed to believe that rising interest rates is this demonic thing that will eat away all of your bond returns.
The fact of the matter is, when you’re talking about a core style portfolio, and I’ll just use the index as a measure, it only has a duration of about, between five and six years. So, what that means is—is that the interest-rate increases that you need to see have to be in the hundreds of basis points over two or three years before you actually lose any money. Most investors that we’re managing money for should have an investment horizon that’s at least three to five years.
And if you do that bond math, most investors would be surprised to say, geez, I guess the thing that would be most beneficial to my portfolio, in terms of a three-to-five-year time horizon, would be—actually for rates to go up. And yes, that’s the answer. Because over three to five years, your portfolio’s returns are going to be dominated—dominated by the income that you earn.
There are three roles for fixed income. There’s the stability role, there’s the core role, which is essentially the offset to the risky markets, and then there’s high-return/high-income style investing. Those are the three buckets. And, when I first started doing this 30 years ago, the US Treasury 10-year note could fulfill any of those buckets.
It doesn’t work that way anymore. Because over the last 12 to 18 months, we’ve had some changes in interest-rate policy, it’s time for a rethink about where is your exposure, and where should your exposure be? Because my guess is way too many people have exposure in the high-income space, when they’re really looking for either an offset to equity market volatility or stability.
Not all markets have the same levels of liquidity. The Treasury market tends to be very, very liquid. As you move further out the credit spectrum, and the issuers get smaller and more diverse, the liquidity gets worse. And the area that has the least level of liquidity is the highest credit-risk securities in the corporate market.
The markets for lower-credit-quality securities tend to come and go, and not be ideal. And, I mention the word “securities” there for a reason, because high-yield bonds are securities. There’s a CUSIP, they trade, everybody knows. Bank loans are not a security. They’re a loan. And so, they would trade with that much less liquidity than would high-yield bonds.
So, worry more about the credit cycle, worry less about the interest-rate cycle, and you’ll sleep better at night.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.