Volatility in the Equity Market and the Role of Bonds

After reaching a high on February 19, COVID-19 and the decline in oil prices drove selling pressure on the Standard & Poor’s 500, leading to a 34% decline by March 23. Actions taken by the Federal Reserve Board and spending programs by the federal government have helped this equity market index climb by almost 36% from the March low. I want to review how bonds have performed during this equity market volatility and our current fixed income strategies.

In previous newsletters, we have reviewed why we hold fixed income securities and bond funds but a refresher is provided below:

• Fixed income may provide diversification benefits by exhibiting different price movements, at different times, than the equity markets, providing principal protection and reduced price volatility in your overall portfolio.
• We are employing a defensive interest rate strategy by building our bond portfolios with an intermediate maturity structure. Prices will still decline if rates rise, but not to the same degree as if longer maturity bonds were held.
• We create well diversified portfolios, across multiple issuers and sectors.
• We often see opportunities to add other types of fixed income funds, for example, international bond funds, to increase return potential and/or provide additional diversification.
• Fixed income provides pre-tax and after-tax income.
• Rising interest rates may provide an opportunity to reinvest cash flow into fixed income securities and funds at increasingly higher interest rates.

High quality bonds have performed well versus equities during this market volatility. On a year-to-date basis, the 4-year average maturity bond market index that we share with clients has returned a positive 3.6% and has returned a positive 7.8% over the last 12 months. Over the same year-to-date and 12 month time periods, the Standard & Poor’s 500 has returned -10.3% and -0.1%, respectively.

But within the bond market, different securities have performed in different ways. This 4-year average maturity bond index is allocated approximately 66% to government securities and 34% to corporate bonds. US Treasury securities have performed particularly well during this volatile period for equities, as the interest rates on Treasury securities have fallen and prices have risen. The prices on high quality corporate bonds, and even high-quality municipal bonds, have declined over this same time period. These sectors of the bond market have been negatively impacted by a number of factors: investors selling bonds to raise cash, reluctance on the part of bond dealers to buy bonds unless they have buyers lined up to purchase bonds, concern with potential deterioration in credit quality as the economy shuts down, and concern with financing and re-financing opportunities for corporations and municipalities.

In response to the virus and the anticipated impact on the economy and financial markets, in March, the Federal Reserve lowered its target for the federal funds rate to a range of 0% to 0.25%. While this is the rate at which banks borrow and lend funds with other banks, the rate also impacts the return available on other securities. For example, the interest rate on three month Treasury Bills has declined to 0.12%. The return on money market funds which invest in Treasury securities has declined to under 0.25%.

In response to the trading disruptions in the corporate and municipal bond markets, the Federal Reserve announced programs to purchase government, corporate, mortgage backed and municipal bonds. These actions, as well as the announced government spending programs, have helped stabilize the investment grade corporate and municipal bond markets.

Our fixed income portfolios have performed relatively well. Over the last few years, we have increased the average credit quality of portfolios by selling the bank loan fund that was held across portfolios, reducing the allocation to intermediate maturity corporates, investing in shorter maturity corporates and increasing our allocations to US Treasury Notes and to a US Treasury Inflation Protected Securities (TIPS) fund. We hold a small allocation to an emerging markets debt fund which has declined in value but we continue to believe that this investment will provide return and diversification benefits longer term for our clients’ portfolios. We also hold a high yield municipal bond fund in our client portfolios that are focused on generating tax-preferenced income. This fund has had a modest price decline year-do-date, but has performed competitively with peers.

Volatility also provides opportunity. In response to the decline in prices and increase in interest rates on investment grade corporates and US agency securities, we are increasing our target allocation to corporate bonds and modestly extending the average maturity of our corporate bond purchases. These allocation changes may occur through the purchase of individual corporate bonds or an intermediate maturity corporate bond fund. We are also initiating an allocation to intermediate maturity US agency bonds or a fund that invests in agency bonds. Finally, we are continuing to add tax exempt municipal bonds to our portfolios, in some cases, at pre-tax interest rates which are higher than the returns available on comparable maturity US Treasury securities.

Bonds continue to play a key role as part of a diversified portfolio. Please call your client centric team members if we may help with anything.