Is There Any Place to Hide from Market Turmoil?
It’s only a matter of days before August month-end brokerage statements will arrive in the mailboxes of millions of investors across the country. It’s fair to assume that most people are not looking forward that moment, assuming they have picked up a newspaper at all in the last month. The question many people will be asking themselves (or their financial advisors) is what adjustments they can make to their portfolios to avoid further market turmoil and still stay invested.
Despite what the financial press may tell you, there are still places to invest that provide positive expected returns without incurring a large amount of risk. One such place is in shorter maturity investment grade corporate bonds.
Short-dated bonds are not what most people talk about when it comes to investment opportunities, but they do have a place in most portfolios, especially during times with heightened macroeconomic uncertainty. With the Fed about to raise interest rates, China slowing more rapidly than previously expected and commodity markets experiencing stresses not seen since 2008, the inclusion of defensive strategies in a portfolio could go a long way to preserve overall value and provide the confidence investors need to stay invested in other more aggressive investments.
An allocation to short-dated investment grade corporate bonds can provide several benefits to a portfolio:
Insulation from swings in interest rates due to a low overall average duration
Excess return compared to cash
Positive expected real return (return in excess of the inflation rate)
A low or negative correlation to equities
As you can see from the table above, CSJ has a yield of 1.59%, an effective duration of 1.93 years and a 30-day volatility of 1.1%. At first glance, if you looked only at the yield to maturity, you might conclude that there is little value in the sector compared to the others. However, looking at yield alone does not give you any insight into expected risk-adjusted returns. Yield should be evaluated in context of other factors, including interest rate sensitivity (duration), the volatility of the sector, and possible losses from default.
It is important to note that a bond’s yield to maturity is only one component of its total return. Other factors that influence a bond’s total return are defaults that may occur as well as the slope of the yield curve. While this article provides a more thorough explanation, essentially a normal yield curve provides additional return through what is known as “roll down.” Obviously, the steeper the slope of the yield curve, the more additional return will be generated through the roll down. One to three year investment grade corporate bonds, for example, currently roll down at a rate of approximately 50 bps per year. For a 2-year bond, this would translate into an additional 0.50% in return during the first year, assuming the shape of the yield curve remains constant.
Duration measures the sensitivity of a bond’s price to changes in its yield. The higher the duration, the more sensitive a particular bond, or bond portfolio, will be to movement in interest rates. One way to compare different sectors of the fixed income market is to look at expected yield relative to duration. In other words, how much yield is offered for every year of duration? Simply dividing the yield by the duration provides the following results:
When the yield is adjusted to reflect the shorter duration, CSJ compares favorably against all the other sectors. CSJ has a yield of 80 bps for every year of duration. The only sector that provides a higher yield per unit of duration is the high yield sector at 161 bps.
For fixed income instruments, volatility is closely tied to duration. However, some segments of the fixed income market, like high yield corporate bonds, have additional volatility stemming from investors’ views on defaults, recovery in the event of a default, and liquidity. Higher default risk and lower liquidity are not captured in the duration, but are represented in the volatility of high yield bond prices. Using a similar methodology as above, we can risk-adjust for these factors by simply dividing the yield by the 30 day volatility.
Using this measure, you can see that CSJ provides the highest yield per unit of volatility. The high yield markets does not appear as attractive when volatility is taken into account.
Moving from a risk free asset class (from a default perspective) like US Treasuries to corporate bonds must include an evaluation of default risk. The yield of a corporate bond portfolio should reflect this risk. Investment grade bonds have historically had very low default rates, especially when viewed over a one-year time period. Typical one-year default rates for investment grade corporate bonds range between 0.08% and 0.13%, depending on what period is used in the analysis. Studies form Moody’s and S&P provide consistent results. A default rate of 0.08% to 0.13% is very low, and should not have a meaningful impact on the portfolio yield.
One way to measure liquidity is in the size of the bid/ask spread to trade a particular instrument (in this case all of the instruments in question are ETFs). The graphs below illustrates the bid-ask spreads (as a percentage) for various ETF sectors along with the average dollar value traded every day over the last 3 months.
According to these measures, CSJ is slightly less liquid than most of the other sectors, but not significantly. CSJ’s average bid-ask spread is 0.019%, which translates to about 2 cents on the current price of CSJ at $105.09. As for the average daily value traded, while there is not sufficient liquidity for institutional investors to allocate large flows in and out of the sector every day, at $50 million in daily turnover, there should be plenty of liquidity for retail investors to get involved.
A final factor to consider before making any portfolio allocation is to compare the correlation of the sector’s daily total returns to those of other sectors in the fixed income asset class as well as to other asset classes, such as equities. The graph below shows the daily correlation between CSJ and other ETFs over the last year.
While CSJ is loosely correlated to the other fixed income ETFs, it is negatively correlated to SPY, the S&P 500 ETF. A low negative correlation to SPY indicates that CSJ should not be adversely affected by the day-to-day swings in the equity market.
The recent market turmoil has forced many investors to re-examine their portfolios and assess whether they are taking the appropriate amount of risk for their given circumstances. There is a tendency for people to think about allocations in their simplest form: government bonds, equities and cash.
So IF you choose to open the brokerage statement from last month, and IF a more defensive allocation is required, recognize that cash or government bonds are not the only alternatives. Short-dated investment grade corporate bonds have many of the defensive features of government securities with an expected return that is meaningfully higher.