Ice Hockey is a fast-paced sport. Coaches drill their players to “skate where the puck is going to be, not where it has been.”
This advice can be applied to many fields. Investment is one of them. It is well known that investors tend to chase returns by buying more of a stock or fund that has performed well, and vice versa. To some extent this behaviour makes sense: If the information an investor has is lacking or imperfect, confirmation of an investment idea through price action will increase the confidence in that idea. Nonetheless, this is skating to where the puck has already been, and for bond investors this sort of approach can be problematic.
Bond investors tend to chase returns in another way as well – by increasing the risk they take to maintain or increase their yield. Bond yields have dropped over the last thirty years. Initially this was due to inflation expectations becoming anchored. More recently, quantitative easing programmes have compressed bond yields, and economic growth expectations have fallen as well. For investors relying on bonds as a source of income there are now two choices: accept a reduced income; or take more risk to maintain current income levels. Most do the latter, and time and again at Daintree we see bond portfolios that investors believe to be defensive that are anything but.
In this note we will first discuss why chasing returns in bonds is a bad idea; then we will discuss why chasing yield can make a bad idea worse.
We start with a chart of the quarterly returns of the Bloomberg Composite Bond Index since its inception in September 1989. These quarterly returns have ranged from -3.5% to +7.5%:
What do returns in one quarter imply about subsequent returns? Is a high return at the end of a quarter associated with higher returns in the following quarter? If chasing returns in fixed income was a sensible strategy, we might expect so. But when we look at the data this is not borne out – most of the time the return in the next quarter is lower, not higher, than the return earned in the current quarter:
Source: Bloomberg, Daintree Capital
This chart shows that the higher the return in a given quarter, the lower the return in the next quarter is likely to be. In other words, it shows that investors should not focus on where the puck has been, but on where it is going to be! That doing otherwise will destroy wealth is clearly backed up by data. It is also intuitive: bonds are a contractual obligation between an issuer and investors. The issuer agrees to pay a certain rate of interest over the life of the bond. At maturity, the also issuer agrees to return principal to investors. For an investor holding a bond from issue to maturity, this means returns are wholly dependent on the interest that the issuer promises to pay. Any increase in the price of a bond will be fleeting – investors in bonds do not invest for large capital gains, which are the preserve of other asset classes. There are two implications of this:
1) If bond yields fall (as prices rise), future returns will be lower as income is re-invested at lower yields.
2) Whilst there is no prospect of a permanent capital uplift if an investor buys a bond at issue and holds to maturity, there is a prospect of permanent capital loss! A bond issuer may decide to not return investors’ principal, defaulting on their obligation to pay. This is credit risk.
Playing defence in ice hockey can be really challenging. A flat-footed defence player will not be successful.
Bonds are an important defence to a diversified investment portfolio, and a portfolio without defence is one that is prone to large losses. With that in mind, we now turn to the relationship between credit risk and returns. Credit risk can be a very stable source of excess returns for investors through time. Of course, as is the case for any investment risk, there are also pitfalls for investors who chase yield and bias their portfolios too far down the credit risk spectrum. By doing so, such investors increase the potential for both increased portfolio volatility and loss of capital. At Daintree, we see many investors with credit exposures that are excessive and/or lacking in diversification given the defensiveness they expect from their fixed income assets.
The charts below show the implications of taking too much credit risk in a bond portfolio. The default frequency of bonds globally is shown over time, grouped by credit rating, as measured by the credit rating agency Moody’s. The higher the default frequency, the greater the number of companies that did not remit interest or return investor capital in full:
Source: Moody’s Investor Service Annual Default Study: Corporate Default and Recovery Rates, 1920 – 2017
We can make two points:
1) Defaults happen during and following stressful periods for markets: The 1990-1991 recession, the tech bubble of 2000 and the 2008-2009 financial crisis all saw pickups in the rate of defaults, across both investment grade and sub-investment grade issuers.
2) Defaults are much more prevalent among sub-investment grade issuers: Sub-investment grade issuers experience default much more frequently than investment grade issuers.
These are the pitfalls of investing solely for yield. Permanent capital losses can occur and are more likely to occur when other assets in a portfolio are also underperforming due to a weak economic environment. But even if there is ultimately no permanent loss of capital, credit investors can face volatility. Our final chart shows the rolling annual Sortino ratio of high yield credit, and equities*. The risk-adjusted returns of credit are superior to equities in good times, but inferior in bad times:
Source: Bloomberg, Daintree Capital
Chasing yield is like a team with no defence – heavy losses are inevitable at some point.
In this note we have examined the consequences of chasing returns in fixed income. An investor may chase returns simply by increasing the size of their investment after a period of good performance, which we have shown is likely to reduce returns over time. An investor may also increase the amount of credit risk they take. Credit investing should be undertaken with clear advice, active management and sensible diversification; otherwise, significant losses can occur at the same times that growth asset returns elsewhere in a portfolio are also falling.
At Daintree, we see too many investors chasing returns and assuming the future will look like the past. On the other side of the equation, we also see too many investors who may not necessarily be chasing returns, but who chase yield by taking on too much credit risk for what should be considered the defensive portion of a portfolio. These higher credit risk portfolios will exhibit greater volatility in good times; and could suffer materially worse performance in bad times. This is the investing equivalent of skating to where the puck has been in a team with nobody playing defense. The result is going to be heavy losses that start from early in the game and get worse from there.
Daintree Capital fixed income portfolios aim to achieve sensible return objectives. We take the necessary amount of risk to achieve those objectives, and no more. All the while, capital preservation remains our top priority. Our view is that fixed income portfolios should be managed in this way, because the defensive characteristics that investors typically seek may otherwise by compromised.
Disclaimer: Please note that these are the views of the writer and not necessarily the views of Daintree Capital. This article does not take into account your investment objectives, particular needs or financial situation.
*The Sortino ratio is very similar to the Sharpe ratio, but it only considers downside volatility as opposed to all volatility. It is the return above cash, divided by the volatility of negative returns. If an investment generates a higher return it will have a higher Sortino ratio, but if it does this while generating significantly negative returns the Sortino ratio will be lower.