By Gene Tannuzzo, CFA, Senior Portfolio Manager
Following cold, snowy weather throughout much of the U.S. earlier in the year, we are all happy to welcome summer. We don't need to look back any further than the recently released report of Q1 GDP (showing a larger-than-expected contraction of 2.9%) to recall the frustration and disappointment that the weather delivered. While the warmer weather brings feelings of excitement and anticipation, global bond markets have been providing something much less exhilarating: utter and complete boredom.
The combination of slow global growth and ultra-stimulative policy from central banks around the world has helped drive volatility across markets to remarkably low levels. Across equity, bond and currency markets, we can see the decline in price volatility on a daily basis. Furthermore, option prices in each of these markets imply that the era of small price movement is here to stay, or perhaps investors are simply far too complacent.
Given the low level of volatility today, investors are in a precarious position: stay invested in the market at low yield levels, or step to the sidelines awaiting a better entry point. A closer look at bond returns in low-vol environments can help shed some light on the subject. Using Merrill Lynch's MOVE Index measuring implied volatility in interest rates, we look back over the past 20 years, dividing the market into four quartiles based on the level of volatility. Then, using high yield corporate bonds as a proxy for credit risk, we assess the prospective returns that bond investors have earned based on the starting volatility level.
While low volatility environments often overlap with low yield environments, it would be easy to assume that prospective returns from corporate bond investing would be unattractive in a low-vol world. The evidence, however, suggests that this is not the case. Starting from periods of low interest rate volatility, high yield returns have generally been respectable, returning just under 7% on average (Exhibit 1). Furthermore, high yield has generated its highest Sharpe ratio (return-per-unit-of-risk) in low-vol environments. So while yields may seem low in absolute terms, they may not actually be all that low when compared to the level of volatility in the marketplace.
Sources: Barclays, Morgan Stanley, Columbia Management
So then is the optimal bond portfolio in this environment simply the one with the highest yield? We think the answer is not that simple. Our second, and perhaps more important, long-term conclusion gets back to the original observation. When implied volatility is low, investors are not expecting conditions to change materially in the near future. In simple terms, insurance is cheap. While we think it is important for investors to retain exposure in the bond market, it is important to be flexible and find inexpensive forms of risk protection. These may include using various instruments that protect bond portfolios against higher interest rates, wider credit spreads or falling values of foreign currencies.
History has shown that volatility can stay low for extended periods. In that case, we would expect credit sensitive assets to continue to generate reasonable returns. That said, surprises only happen because people aren't expecting them. As such, investors should take advantage of strategies that protect the downside, especially when the price of insurance (i.e. volatility) is low. Exhibit 2 illustrates how we are positioning flexible fixed income portfolios in today's market environment.
Source: Columbia Management Investment Advisers, LLC
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