Weekly Market Review
In this recap, we summarize market performance and market moving news from the prior week.
Across asset classes, interest in passive investments has grown over the past several years, and passively managed fixed income funds have been gaining traction. Over the last decade, net flows into passive fixed income funds and ETFs have climbed from 24% to more than half of flows (53%).1 What is not always clear to investors, though, is that unlike in equity indices where the largest companies have the heaviest weightings, fixed income benchmarks are often debt weighted. This means that issuers with the most outstanding debt have the largest weightings in an index. Additionally, passive fixed income’s rise in popularity has coincided with interest rates falling to historic lows. Subsequently, index returns over the past several years have been a fraction of what they had been in the 1980s and 1990s.
This declining return trend has been compounded by the two most recent economic crises—namely, the Global Financial Crisis (GFC) and the Covid-19 pandemic—both of which resulted in an array of stimulus measures and government debt issuance. For perspective, since the beginning of the GFC, outstanding U.S. government debt has tripled.2 The GFC and Covid-19 together inspired an unprecedented stretch of quantitative easing from the Federal Reserve, which resulted in the balance sheet expanding to more than eight times its original size.3
This increase in outstanding government debt and the Federal Reserve’s bloated balance sheet have combined to lower the yield and lengthen the duration of the Bloomberg Barclays US Aggregate Bond Index. From the end of 2007 to the end of 2020, the index’s yield to worst fell 370 bps, while duration lengthened by nearly two years.4 In short, passive investors are accepting even lower yields, while increasing their interest rate risk.
Ongoing uncertainty around the pandemic and the Federal Reserve’s commitment to maintaining an easy monetary policy suggest that this shift is unlikely to revert anytime soon. The Fed’s target interest rate is expected to remain near zero through 2023, with the long-term rate expectation at 2.5%. Given these historically low yields, investors would be well advised to consider every opportunity to earn additional return. While the effect of a single extra percentage point is not that noticeable in the short term, the compounding effects over the long term can have a significant impact on asset growth.
Investors seeking to enhance return in today’s persistent low rate environment should consider actively managed core plus bond funds. Core plus funds have the flexibility to allocate to fixed income sectors which have historically outperformed, while the Bloomberg Barclays US Aggregate Bond Index has a 91% weighting to just three sectors and little to no exposure to the fixed income sectors with the highest historical rates of return.5 An active manager can help investors gain access to these higher-yielding sectors—such as high yield and emerging market debt—while keeping an eye on risk.
By expanding the target opportunity set, core plus bond funds have gained an advantage. Based on rolling 5-year returns, intermediate term core plus bond strategies have outperformed intermediate term core strategies 91% of the time.
In rising rate environments, the flexibility of active managers—and more specifically of active core plus strategies—has provided additional opportunities for return. Historically, active intermediate core and core plus strategies have outperformed their passive counterparts in rising rate environments. The table below shows average excess returns for active and passive bond funds during periods where the 10-year Treasury yield increased by a minimum of 75 bps. On average, active core plus bond strategies consistently offered more excess return than core and passive core plus strategies.
In past decades, interest rates were significantly higher than today, and provided investors with enough return to buoy income, plump nest eggs, and fund retirements. Today’s lower rates, however, create a gap between current savings and future cash needs. The additional return that active fixed income managers may provide is playing an increasingly important role in helping to bridge that gap.
PGIM Investments can help you prepare your portfolio for this low-rate environment.
1 Morningstar as of December 31, 2020.
2 U.S. Treasury Department. Outstanding debt was $9,229 billion and $27,747 billion for December 31, 2020 and December 31, 2011 respectively.
3 Federal Reserve. The balance sheet for the Fed was $891 billion and $7,364 billion for December 26, 2007 and December 30, 2020 respectively.
4 Barclays. Yield to worst moved for the Bloomberg Barclays US Aggregate Bond Index was 4.9 and 1.2 for December 31, 2007 and December 31, 2020 respectively. The modified duration for the Bloomberg Barclays US Aggregate Bond Index was 4.4 and 6.3 for December 31, 2007 and December 31, 2020 respectively.
5 Morningstar as of December 31, 2020. Based on average rolling 5-year return of the JPM EMBI Global Diversified Index (emerging markets) and Bloomberg Barclays US Corporate High Yield Index (high yield) from December 31, 2003 to December 31, 2020.
Representative indices for the chart titled "Many Top-Performing Fixed Income Sectors are Underrepresented" are as follows: High Yield(HY): BBgBarc US Corporate High Yield Index; Loans: S&P/LSTA Leveraged Loan Index; EM Hard Currency: JPM EMBI Global Diversified Index; Municipal Bonds (Muni): BBgBarc Municipal Index; IG Corp: BBgBarc US Corp Bond Index; Commercial Mortgage Backed Securities (CMBS): BBgBarc CMBS ERISA Eligible Index; Motgage Backed Securities (MBS): BBgBarc US MBS Index; Asset Backed Securities (ABS): BBgBarc ABS Index; US Treasuries: BBgBarc US Treasury Index.
Risk Information—Investing involves risk. Some investments are riskier than others. The investment return and principal value will fluctuate, and shares, when sold, may be worth more or less than the original cost. Diversification does not assure a profit or protect against loss in declining markets. These risks may increase a fund’s share price volatility. Fixed income investments are subject to interest rate risk, and their value will decline as interest rates rise. High yield bonds, known as junk bonds, are subject to a high level of credit and market risk. Unlike other investment vehicles, US government securities and US Treasury bills are backed by the full faith and credit of the US government, are less volatile than equity investments, and provide a guaranteed return of principal at maturity. Foreign securities are subject to currency fluctuation and political uncertainty; emerging markets are subject to greater volatility and price declines; and foreign currency may change in value relative to other currencies. International investing can expose investors to certain geographic and economic sectors, thereby increasing vulnerability to a single economic, political, or regulatory development. Actively managed portfolios may carry additional risks, such as that analyses performed cannot always predict outcomes, that the investment techniques applied do not have the expected results, and that external factors can change the course of investment performance. The fees associated with active management may be higher than those associated with passive strategies. Asset allocation and diversification do not assure a profit or protect against loss in declining markets. There is no guarantee an investment’s objective will be achieved.
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The indices are presented to provide you with an understanding of their historic long-term performance and are not presented to illustrate the performance of any security. The indices and averages defined above are unmanaged. Investors cannot invest directly in an index or average. Past performance is not a guarantee of future results. Individual investor results will vary.
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