Quantitative Un-Easiness



  • Years of relying upon attractive dividend yields in relatively tranquil stock markets appear to have ended with last autumn’s return of volatility.
  • At the same time, higher yields on shorter-dated bonds may provide an attractive alternative for income-oriented investors.
  • As uncertainties abound, increasing one’s allocation toward shorter-dated bonds may serve as a bulwark for a portfolio given these securities’ traditionally defensive characteristics.

By Nick Maroutsos

Nick Maroutsos, Co-Head of Global Bonds, explains why higher yields on shorter-dated bonds may prove attractive for income-focused investors rattled by rising equity market volatility.

Perhaps simply "queasiness" is more fitting. Certainly, that's an apt feeling among investors having stomached sharp falls in riskier asset prices in the last quarter of 2018, again bringing into focus the question of asset allocation as investors consider the path ahead. While many of the surprise falls have reversed, at least in part, through January this year, it's important to consider what may have driven the sharp declines, and the question is whether they are a temporary setback or symptomatic of a more prolonged malaise. While this is impossible to answer with any degree of certainty, it's hard to ignore the secular shift in the comparable risk/reward metrics of major asset groups, driven by changes in macroeconomic dynamics and an ever-fluid political backdrop.

Equity markets have barely missed a beat while rewarding investors for much of the post-Global Financial Crisis period, buoyed by central bank monetary stimulus. The combination of a stable tiller and cheap money can be an intoxicating mix. But now, perhaps if the initial U.S. experience is anything to go by, we're seeing for the first time in a long while the impact of having "the training wheels off," of borrowing costs moving back to a more normalized level, on a jittery equity market.

What we are faced with today is a shifting set of relative market dynamics, combined with a much less certain political landscape, with neither being especially "equity-friendly."

One thing that is arguably different in 2019 as we contemplate asset allocation going forward is the risk premium - or simply, the forecast return spread between cash and bonds, and equities. The roughly 1% cash rate environment of the past decade has been utopia for equities; dividend yields of 4% or 5% easily made them the darling of any asset allocators tool kit. But now that U.S. cash rates have exceeded 2%, the cost of doing business has changed markedly and the dividend yield return spread is less attractive. And that's before we factor in the tailwind a potential rising rate environment should, in our view, ultimately bring to sovereign and credit yields. Sure, there can be some pain on the way toward high yields if duration exposure is left unhedged, but the forward-looking potential for returns from those asset classes today looks a whole lot more appealing. The yield on 10-year U.S. Treasuries has been oscillating between 2.5% and 3.0%, and investment-grade credit yields sit comfortably above 4% at the medium to long end of the curve.

It is said "every cloud has a silver lining," and as Exhibit 1 below illustrates, the combination of sporadically widening spreads between corporate credits and their underlying risk-free benchmark, along with rising rates - both of which characterized much of 2018 - we believe, benefited bond investors. Higher yields across the maturity curve proved attractive, while there was no discernible elevation in an already modest level of default risk. Suddenly, an equity dividend yield of even 5% doesn't feel quite as rich, and almost certainly not on a risk- or volatility-adjusted basis.

Exhibit 1: U.S. Investment-Grade Corporate Credit Yields

Source: Bloomberg

All this, and not even a mention of the specific but wide-ranging instances of political instability brought about by populism and anti-globalism and protectionism, a number of which individually have the power to materially disrupt global trade and harmony.

After all the noise of 2018, those carrying the most defensive strategic asset allocations, in many cases, came out ahead - a worthy reminder that through cycles there will always be periods where it pays to bias one's objectives toward preserving money just as much as growing it. Regardless of whether risk asset volatility of the past couple of months proves to be temporary or more sustained, higher cash and bond yields certainly signal a harder environment for equities to maintain the strong competitive edge that they have enjoyed over the past decade.

This environment has developed as one where optimal balancing between prudent defense and sensible return-seeking becomes paramount. Investors may be well served to prioritize maximizing potential returns while attempting to insulate against observable risks.

In a practical sense, this could mean extending duration in countries that are likely a long way from raising interest rates, with Australia being an example; cautiously approaching U.S. duration until there is greater clarity on the direction of the path the Federal Reserve may take; and largely avoiding much of Europe.

Shorter-maturity profiles, in our view, should prove beneficial in insulating portfolios from continued widening of spreads and resultant price decreases that typically stem from them.

The likelihood is that this remains an environment where a strong constitution is important. Take a few deep breaths, and to borrow from Nat King Cole, while there may be trouble ahead, we must face the music and dance. But perhaps from the edge of the dance floor, and be ready for a swift exit should the music stop abruptly.


Fixed income securities are subject to interest rate, inflation, credit and default risk. The bond market is volatile. As interest rates rise, bond prices usually fall, and vice versa. The return of principal is not guaranteed, and prices may decline if an issuer fails to make timely payments or its credit strength weakens.
Foreign securities are subject to additional risks, including currency fluctuations, political and economic uncertainty, increased volatility, lower liquidity and differing financial and information reporting standards, all of which are magnified in emerging markets.

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