Diversify to defend against portfolio drawdowns
May 13, 2019
The new rate regime challenge for financial advisors Edward Kerschner, CFA, Chief Portfolio Strategist
I think financial advisors are facing what, for many of them, is going to be the biggest challenge of their career, what we call the new rate regime.
I think we're entering a period of normal and we've just been through a period that has been extremely abnormal, in terms of interest rates.
Interest rates have been coming down for four decades. And as you know, when rates go down, bond prices go up a little bit. But when rates are high and go down, it's great, because you get your 10% or 8% or 6% yield plus a little gain. All you had to do was you had to play duration, right? You made close to 8.5% a year for about four decades…1981 to 2017, return from the 10-year Treasury, 8.3%. Thirteen years of double-digit returns, four years over 20%, only five negative years.1
So all you really needed to do is be long-duration.2 And you could buy a cheap solution and you could have been a hero. But in the new rate regime where it's, rates aren't going to go down 500 or 600 basis points, because they're not…and look at 3%, you can't go down 600 basis points. So I think as advisors you're going to have to depend upon the other factors that drive return in the bond market.
So I think you're going to have to use solutions that incorporate more than duration. Which is what most of us debate today, "Gee, do you think there's duration risk? How much duration risk is there?" When, in fact, there's duration risk and opportunity, but there's also credit, there's also FX currency, there's also inflation.
And I think you're going to have to be using more sophisticated solutions. Look, the return from the Agg, 98% of it's duration.3 And going forward, duration's not going to be the total source of return in the bond market. Duration, credit, foreign exchange, inflation: multi-factor solutions that you didn't have to use, I think you're going to have to use to generate returns for your clients.
The views expressed are as of December 2018, may change as market or other conditions change and may differ from views expressed by other Columbia Management Investment Advisers, LLC (CMIA) associates or affiliates. Actual investments or investment decisions made by CMIA and its affiliates, whether for its own account or on behalf of clients, may not necessarily reflect the views expressed. This information is not intended to provide investment advice and does not take into consideration individual investor circumstances. Investment decisions should always be made based on an investor's specific financial needs, objectives, goals, time horizon and risk tolerance. Asset classes described may not be suitable for all investors. Past performance does not guarantee future results, and no forecast should be considered a guarantee either. Since economic and market conditions change frequently, there can be no assurance that the trends described here will continue or that any forecasts are accurate.
There are risks associated with fixed-income investments, including credit risk, interest rate risk, and prepayment and extension risk. In general, bond prices rise when interest rates fall and vice versa. This effect is usually more pronounced for longer term securities.
1 U.S. 10-Year Treasury bond returns, 1981-2017. Source: Bloomberg, Columbia Threadneedle Investments. Past performance is not a guarantee of future results.
2, 3 Return from the Agg is 98% duration (interest-rate risk): Source: Blackrock Solutions, Columbia Threadneedle Investments, as of 12/31/18. Based on the risk composition of the index. Past performance is not a guarantee of future results.
The Bloomberg Barclays US Aggregate Bond Index (U.S. Aggregate) is a broad-based benchmark that measures the investment grade, U.S. dollar-denominated, fixed-rate taxable bond market. The index includes Treasuries, government-related and corporate securities, MBS (agency fixed-rate and hybrid ARM pass-throughs), ABS and CMBS (agency and non-agency).
It is not possible to invest directly in an index.
A basis point is 1/100th of a percent.
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