Three Options for De-clawing a Bond Bear
Author: David Stonehouse
November 26, 2020
There is a high probability that a cyclical bond bear market is on its way, but as we argued in the second part of this blog series, its hardly cause for panic: investors are unlikely to experience returns much worse than low-single-digit negative territory for the overall bond index.
Still, while that might come as a relief to some, nobody wants to lose ground with their investments, nor do they necessarily have to. In fact, there are several strategies and tools for mitigating downside risk and adding value during cyclical bond bears like the one we expect. One is relatively obvious: adjusting the duration of the fixed-income portfolio towards the short end of the curve, where the adverse impact of rising rates should be limited. Inflation-linked bonds are also an option, if it appears that inflation is mounting a return as the economy recovers. Perhaps most importantly, in advance of a cyclical bear market, it’s a good time to consider balancing traditional government bond exposures with other income-generating vehicles – high-yield, convertible and emerging market bonds, in particular.
While we view the U.S. and global economy to be in the early stages of recovery, full recovery could take some time, and the number of companies declaring bankruptcy and defaulting on their debt is likely to rise. Counterintuitive though it might seem, times like these have historically been good for corporate credit, and especially for high-yield (below-investment-grade) bond returns. Why? Severe recessions tend to lead to corporate deleveraging, which helps purge credit markets of overleveraged companies and create new opportunities for investors. Furthermore, the market tends to overreact to the downside, and the debt of many companies may de-rate to a substantial discount, presenting opportunities for astute investors who can discern credits that can avoid default and trade back up to par values.
Consider the Great Financial Crisis of 2008-2009. U.S. credit markets troughed 10 months before the default rate peaked; by the time it had, investment-grade bonds had returned 17% and high-yield bonds 49%, according to research from Bank of America Merrill Lynch. Another way to look at it: it took nearly 18 months for bankruptcies to top from their trough, and during that time IG corporates and high-yield returned 21.4% and 65.5%, respectively. While high yield bonds have already rebounded strongly and produced double digit returns from the March trough, we believe they still have good potential to outperform in the coming year.
During the past six cyclical bond bear markets, convertible bonds – corporate debt instruments that pay a coupon and can be converted into common stock, usually at lenders’ discretion – have proven to be a strong hedge. During those periods, convertibles have consistently and significantly outperformed traditional bonds (see chart). Moreover, they have a low correlation to other types of fixed income, which can make them an important diversifier. And their potential to convert into equity provides upside potential in a strong equity market, while their standing as a bond provides downside protection in a weak equity market. Perhaps best of all for fixed income investors concerned about the potential for rising yields, convertibles have generally historically delivered positive returns when regular bonds have experienced negative returns.
Convertibles have historically performed strongly in rising yield environments
Emerging market bonds
Many investors will recall that during the last cyclical bear, from early 2016 to late 2018, emerging market bonds did not perform well: the J.P. Morgan Emerging Markets Bond Index (EMBI) declined by more than five percent. But it’s important to also recall that this occurred during a period of relative U.S. dollar strength, and while the U.S. Federal Reserve was raising interest rates. We don’t expect either of those factors to be at play in the current environment. In fact, a more accurate precedent today might be the Global Financial Crisis and the cyclical bear that followed it, when EM bonds performed admirably. After troughing in October 2008, the EMBI gained nearly 12% in the following four months, and it went on to rise by another 35% to the end of the cyclical bear in early 2010.
This time around, EM bonds have gained nearly 18% since troughing in March, and they have the potential to continue the run. Near-zero interest rates from the Fed should alleviate pressure on EMs with high U.S.-dollar-denominated debt, while elevated U.S. debt should work against much further appreciation in the greenback. Meanwhile, emerging market economies (admittedly, some more than others) and their bonds should benefit from a rebound in commodity prices and in the global economy as the recovery takes root. Our general approach to emerging market bonds is to be selective; however, the next cyclical bond bear market could accompany a rising tide for the segment as a whole.
As we noted above, the prospect of a cyclical bond bear market should be somewhat less scary for investors than its equity cousin, because the worst it should deliver to a well-diversified fixed-income portfolio is mild disappointment. But why settle for disappointment? By keeping an open mind to income generators beyond government bonds, investors might well be able to do better.
David Stonehouse, Senior Vice-President and Head of North American and Specialty Investments, AGF Investments Inc. is a regular contributor to AGF Perspectives.
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