Seven Lessons Every Fixed-Income Investor Should Learn from 2013

After more than two decades of a fixed-income bull market, 2013 was not a great year for the bond market. Rates bottomed out, many mutual funds had negative returns and bond mutual funds experienced a record $80 billion in redemptions as investors hit the panic button. But it would be foolhardy to assume that 2014 will be a repeat year for fixed income. Rather, the bond market has become more complex and will likely reward those who closely study what worked, what did not and why.

Here are the seven lessons we’ve learned from 2013 and the opportunities they’ve created for investors in 2014:

1)      You can no longer win with just “core.” For nearly 15 years, investing in a core bond portfolio (with at least 85% in investment-grade bonds) practically guaranteed a win, as steadily falling rates helped boost returns. But in 2013, that win streak came to an end: the Barclays US Aggregate Bond Index fell to 2.0%—its first negative calendar-year return since 1999 and the worst since 1994. As a result, many investors need to rethink their fixed-income portfolio to achieve the same level of success going forward.

2)      Own bonds for more than just returns. Just because core and other categories performed poorly in 2013 doesn’t mean it was a bad idea to own them in your portfolio. Bonds offer value beyond their returns, offsetting the volatility of riskier assets in many portfolios, and the performance should be viewed in this context. For example, a portfolio with 60% in the S&P 500 Index and 40% in the Barclays US Aggregate Bond Index performed very well—up 18.6%—with a level of volatility suitable for many investors.

3)      Flexibility trumped the benchmark. While benchmarked investing worked well enough when interest rates were declining—providing a major tailwind to bond returns—unfortunately, rates rose dramatically in 2013. The result: nontraditional or unconstrained strategies performed better than their benchmark counterparts in 2013. (The median manager performance for nontraditional bond funds was 0.63% in 2013, according to Morningstar, versus (1.65)% for intermediate-term bond funds.) Today, almost every bond index offers historically low yields and the same interest-rate risk as before, creating the unintended risk of duration—but unconstrained strategies offer more room to manage that risk.

4)      Bank loans weren’t the bargain people expected. We all knew that rates were going to rise eventually. Accordingly, many investors thought to pile into high-yield bank loans or other floating-rate strategies in 2013 and abandon more duration-sensitive sectors such as high yield. While their logic was right, they didn’t stop to do the math. High-yield bonds performed well despite rising US Treasury yields—the bonds were up 7.4% in 2013, according to the Barclays US Corporate High Yield 2% Issuer Capped Index. Bank loans rose just 5.4% (display).  

2013 Cumulative Returns

5)      Made in the USA isn’t always best. It was wise to go global in 2013, as the Barclays Global Aggregate (USD Hedged) Bond Index outperformed the Barclays US Aggregate Bond Index. But because the economic recovery and actions by global central banks have been uneven, and central banks don’t all do the same thing at the same time, investing globally can help diffuse US interest-rate risk and increase diversification.

6)      The death of US munis was greatly exaggerated. Fears over rising rates and municipal defaults, most notably Detroit’s bankruptcy, exacerbated muni fund outflows to the tune of more than $50 billion in 2013. But many investors were too hasty in jumping ship. While lack of demand caused the five-year AAA municipal yield to rise sharply from 80 basis points in January 2013 to 160 b.p. in June 2013 and it’s been fluctuating ever since, too many investors panicked and thought it no longer made sense to own munis, despite a 0.1% default rate and improving municipality finances (e.g., increasing tax revenues). The result: the sell-off in 2013 created buying opportunities—especially in intermediate-duration munis and lower-rated bonds.

7)      Limited liquidity is the new normal. Regulatory changes impacting the banking community and their fixed-income market-making functions have reduced liquidity in secondary markets. This has intensified volatility and will likely continue to do so. Since the financial crisis, transacting in bonds beyond the most liquid developed government markets has become more challenging as dealers and inventory have waned, and we expect mutual fund flows (including ETFs) to represent a larger percentage of the overall secondary market trading activity relative to the past.

The bottom line is that, despite what happened in 2013, investors shouldn’t turn their backs on bonds. Whether they knew it or not, fixed-income investors have always sought some combination of stability, core and income, and those needs still exist. What has changed, however, is that the 10-year US Treasury note is no longer able to provide the solution it has in the past. Going forward, navigating the bond market is going to be more complicated, and different portfolios will be necessary to suit investors’ diverse needs.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams.

Douglas J. Peebles is Chief Investment Officer and Head of Fixed Income at AllianceBernstein.

Douglas J. Peebles

Douglas J. Peebles joined the firm in 1987 and is the Chief Investment Officer of AB Fixed Income. In this role, he supervises all of the Fixed Income portfolio-management and research teams globally. In addition, Peebles is Chairman of the Interest Rates and Currencies Research Review team, which is responsible for setting interest-rate and currency policy for all fixed-income portfolios. He has held several leadership positions within the fixed-income division, having served as director of Global Fixed Income from 1997 to 2004, and then co-head of AllianceBernstein Fixed Income from 2004 until August 2008. He earned a BA from Muhlenberg College and an MBA from Rutgers University. Location: New York

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2 thoughts on “Are Bonds Really Less Risky than Equities?

  1. Hi Patrick,

    Fascinating study. Thank you for sharing it. I was wondering, when you show real returns of stocks broken down by capital gain and dividend yield, are you subtracting the rate of inflation from the capital gain or from the dividend yield or both? In other words, are you showing nominal yield and real capital gain? Or real yield and nominal capital gain? Or some type of adjustment in between. Thanks again for sharing.

    • The methodology applied by the authors of Triumph of the Optimists: 101 Years of Global Investment Returns is to measure real equity total returns and real equity capital gains. I show the dividend yield as the difference between the two. For example, the real equity total return from 1900 to 1910 was 6.8% annualised; the real equity capital gain was 2.0% and we show the difference between the two of 4.8% as the real yield. Incidentally, the returns to the world equity series comprises a seventeen-country, common-currency (US dollar) index and hence real returns are after US inflation.

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