The common refrain you hear these days about US equity market performance is that it has been subpar and sluggish. The S&P 500 is up 1.2% in total return for the year to date (through June 30) and has struggled to generate upside momentum. Even more sluggish has been the bond market. The Barclays US Aggregate Bond Index, which comprises US Treasury, US government-agency, securitized and corporate bonds is a widely used fixed income benchmark, down 0.14% in year-to-date total return. What’s more, that is a nominal return; even with low inflation, the real return is well into negative territory.
Zeroing in on corporate bonds the picture isn’t much better. The return for the Citi US BIG Corporate Bond Index, a widely used benchmark for investment grade corporate bonds, is -0.81%. Rising US Treasury yields have taken a toll on all bonds and the yield curve has steepened. Yields on long-term bonds have risen more than yields on short-term bonds—which has put pressure on longer-maturity bonds. The other issue facing high-quality bonds has been widening spreads, or a larger gap between the yield on a corporate and that on a like-maturity Treasury. That’s largely a result of a flood of new issues, as companies rush to sell debt before interest rates rise further.
SHORTER DURATION. The few areas of the bond market that are doing well are more "equity like" than "bond like"—high yield bonds, leveraged loans, preferred stocks, convertible bonds and, to some degree, emerging market (EM)bonds—and that’s where fixed income investors need to look for help. What attributes do these asset classes exhibit that have allowed them to outperform? For starters, they’re shorter in maturity and in fixed income the longer the maturity, the more damage done by rising interest rates. For example, the Citi High Yield Market Index, which we use as a high yield benchmark, has an average duration of 4.3 years, while the investment grade corporate index has an average duration of 6.9 years. All else being equal, the high yield bond will outperform investment grade in a rising-rate environment.Higher coupon income—which is the case with high yield, preferreds and EM bonds—allows these asset classes to offset some degree of price decline with higher income. Leveraged loans offer a hedge against higher rates as the majority of these loans have floating coupons that are linked to LIBOR, which will rise as the Federal Reserve hikes rates—something fixed rate bonds don’t offer. Perhaps the most equity-like are convertible bonds. These bonds have lower coupons than if they were conventional bonds, but carry with them the right to convert the bond into equity at a price determined when the bonds are issued. Thus, if the underlying stock performs well, holders of converts have a chance to participate.
PORTFOLIO ADD-ONS. We believe these asset classes should not replace core, high-quality bond holdings, but should be considered as add-ons to portfolios. In our view, rates are likely to rise, albeit modestly, from current levels and, while we may not see the negative returns the bond market experienced in 2013, it is unlikely we will come anywhere near the positive returns the bond market registered in 2014. In fact, nominal returns may end the year barely above zero in traditional fixed income portfolios. In our view, increasing exposure to equity-like parts of the bond market is a way to generate both income and total returns in what is shaping up as a challenging year for fixed income.
Barclays Global Convertibles Index combines three regional indices (the US convertibles index, EMEA convertibles index and APAC convertibles index) into a single, global benchmark.
Barclays High Yield Loans Index measures the performance of high yield, or leveraged loans.
Barclays US Aggregate Bond Index tracks US-dollar-denominated investment grade fixed rate bonds. These include US Treasuries, US-government-related, securitized and corporate securities.
Citi Global Emerging Markets Sovereign Bond Index includes US dollar-denominated emerging markets sovereign debt issued in the global, Yankee, and Eurodollar markets, offering sovereign exposure with broad geographical diversification.
Citi High Yield Market Index tracks performance of below-investment -grade debt issued by corporations domiciled in the US and Canada.
CITI US BIG Corporate Bond Index is a comprehensive representation of the US investment grade corporate bond market.
CITI US BIG Government Sponsored Bond Index is a comprehensive representation of the US government agency debt issues.
S&P U.S. Preferred Stock Index is designed to serve the investment community's need for an investable benchmark representing the U.S. preferred stock market.
S&P 500 INDEX includes a representative sample of 500 leading companies in leading industries in the US economy.
Duration, the most commonly used measure of bond risk, quantifies the effect of changes in interest rates on the price of a bond or bond portfolio. The longer the duration, the more sensitive the bond or portfolio would be to changes in interest rates. Generally, if interest rates rise, bond prices fall and vice versa. Longer-term bonds carry a longer or higher duration than shorter-term bonds; as such, they would be affected by changing interest rates for a greater period of time if interest rates were to increase. Consequently, the price of a long-term bond would drop significantly as compared to the price of a short-term bond.
Bonds are subject to interest rate risk. When interest rates rise, bond prices fall; generally the longer a bond's maturity, the more sensitive it is to this risk. Bonds may also be subject to call risk, which is the risk that the issuer will redeem the debt at its option, fully or partially, before the scheduled maturity date. The market value of debt instruments may fluctuate, and proceeds from sales prior to maturity may be more or less than the amount originally invested or the maturity value due to changes in market conditions or changes in the credit quality of the issuer. Bonds are subject to the credit risk of the issuer. This is the risk that the issuer might be unable to make interest and/or principal payments on a timely basis. Bonds are also subject to reinvestment risk, which is the risk that principal and/or interest payments from a given investment may be reinvested at a lower interest rate.
Bonds rated below investment grade may have speculative characteristics and present significant risks beyond those of other securities, including greater credit risk and price volatility in the secondary market. Investors should be careful to consider these risks alongside their individual circumstances, objectives and risk tolerance before investing in high-yield bonds. High yield bonds should comprise only a limited portion of a balanced portfolio.
The majority of $25 and $1000 par preferred securities are "callable" meaning that the issuer may retire the securities at specific prices and dates prior to maturity. Interest/dividend payments on certain preferred issues may be deferred by the issuer for periods of up to 5 to 10 years, depending on the particular issue. The investor would still have income tax liability even though payments would not have been received. Price quoted is per $25 or $1,000 share, unless otherwise specified. Current yield is calculated by multiplying the coupon by par value divided by the market price.
The initial interest rate on a floating-rate security may be lower than that of a fixed-rate security of the same maturity because investors expect to receive additional income due to future increases in the floating security’s underlying reference rate. The reference rate could be an index or an interest rate. However, there can be no assurance that the reference rate will increase. Some floating-rate securities may be subject to call risk.
The market value of convertible bonds and the underlying common stock(s) will fluctuate and after purchase may be worth more or less than original cost. If sold prior to maturity, investors may receive more or less than their original purchase price or maturity value, depending on market conditions. Callable bonds may be redeemed by the issuer prior to maturity. Additional call features may exist that could affect yield.
Some $25 or $1000 par preferred securities are QDI (Qualified Dividend Income) eligible. Information on QDI eligibility is obtained from third party sources. The dividend income on QDI eligible preferreds qualifies for a reduced tax rate. Many traditional ‘dividend paying’ perpetual preferred securities (traditional preferreds with no maturity date) are QDI eligible. In order to qualify for the preferential tax treatment all qualifying preferred securities must be held by investors for a minimum period – 91 days during a 180 day window period, beginning 90 days before the ex-dividend date.
Asset-backed securities generally decrease in value as a result of interest rate increases, but may benefit less than other fixed-income securities from declining interest rates, principally because of prepayments.
Equity securities may fluctuate in response to news on companies, industries, market conditions and general economic environment.
Asset allocation and diversification do not assure a profit or protect against loss in declining financial markets.
The indices are unmanaged. An investor cannot invest directly in an index. They are shown for illustrative purposes only and do not represent the performance of any specific investment.
The indices selected by Morgan Stanley Wealth Management to measure performance are representative of broad asset classes. Morgan Stanley Smith Barney LLC retains the right to change representative indices at any time.
Investing in foreign emerging markets entails greater risks than those normally associated with domestic markets, such as political, currency, economic and market risks.
Yields are subject to change with economic conditions. Yield is only one factor that should be considered when making an investment decision.
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