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November 07, 2019
The Real Problem with Low Yields
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November 07, 2019

The Real Problem with Low Yields


Macro Insight

The Real Problem with Low Yields

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November 07, 2019

 
 

High grade fixed income plays a special role in managing risk because it tends to be a safer, more liquid and less volatile asset. It acts as the rope a rock climber may clutch onto during precarious times. We still think that is largely true, however, there is a catch. It is that bonds currently are trading at very low yields, even negative yields in many cases. In these conditions, investors who are tied to traditional bond strategies may find they are less effective in acting as a hedge and also have less appreciation potential than when yields were higher. As an alternative, we suggest active fixed income strategies that can offer better diversification benefits throughout changing environments for those willing to assume a greater degree of risk.

Problem: Low yields have eroded diversification benefits

Today’s terrain, however, entails a unique set of risks. Those seeking shelter in bonds should know that, in addition to diminished income streams, the low yield environment has also increased the correlation of returns between fixed income and equities. Increasingly, stocks and bond are moving together (Display 1), meaning investors in a traditionally balanced portfolio, consisting of 60% equities and 40% bonds, may not be getting adequate diversification. 

 
 
 
Display 1: Is your portfolio as diversified as you think?
insight-therealproblemwithlowyields
 

Source: Haver, Bloomberg, Morgan Stanley Investment Management. Data as of October 2019. Bonds represented by the the BofA Merrill Lynch 10 Year US Treasury Index and stocks by the S&P 500 Index. The correlations are  provided for illustrative purposes only and are not meant to depict the correlation of specific investments. The correlations presented are no guarantee of future results.

 
 

We think the low yield environment is the primary contributor to this rise in correlation. Over the past six months, the 10-year German Bund has ranged between -0.70% to -0.20% and US 10-year Treasury from 1.50% to 2.00%. At these levels, there is little room to generate gains from further rate declines. (Display 2). With such little potential for gains, investors cannot look to bonds to potentially offset disappointing equity returns – should that scenario unfold. Similarly, bond yields are not sufficiently high enough to maintain positive performance even for a modest move higher in interest rates.

 
 
 
Display 2: Little room for maneuvering
insight_the-real-problem-with-low-yields-display-2
 

Source: Bloomberg Barclays U.S. A-rated Corporate Bond Index. Data as of June 13, 2018. Data for the 1990s is an average from 1990-1999. Sensitivity analysis is spread neutral. The returns are based on the historical record of how changes in interest rates have affected returns of a representative index. This is provided for illustrative purposes only and is not meant to depict the performance of a specific investment. Past performance is no guarantee of future results.

 
 

 

It thus becomes mathematically more difficult to achieve the benefits offered by diversification when correlations rise. For a portfolio comprised of equity and fixed income, this reduction in diversification benefits may increase the volatility of returns.

Solution: Look beyond the interest rate cycle for bond returns

Since the source of the rise in correlation is the low level of interest rates, then the solution must involve ways reduce the dependency of bond returns from the interest rate cycle.

Active management that looks for opportunities across assets and geographies can help. These flexible strategies have the latitude to generate alpha through in-depth analysis on duration, sectors, credit spreads and yield curve structure. By selectively choosing sectors that have been de-coupled from the interest rate cycle, active managers can seek to preserve the diversification benefits offered by fixed income and potentially improve returns. For example, we can select from global assets whose returns may improve as the economic cycle strengthens, such as credit and some Emerging Market bonds, during periods when interest rates may rise. Similarly, during a declining interest rate cycle we can select higher quality longer duration assets to help capture performance. Keep in mind, investing in these opportunities involve greater risks. Nonetheless, it is this flexibility across a wide investment opportunity set that provides an opportunity for active managers to achieve returns whether interest rates are rising or falling.

The fear of falling is real

Investors concerned about current market conditions and the diminished diversification benefits between stocks and bonds should consider actively managed strategies. An active manager has the latitude to use a variety of tactics to de-couple from the interest rate cycle in an effort to maintain balance and diversification. The fear of falling is real, but knowing that there is someone at the helm continually looking for opportunities and seeking to guard against risks can provide an anchor in uncertain times.   

 
 

Risk Considerations

Diversification does not eliminate the risk of loss.

Fixed-income securities are subject to the ability of an issuer to make timely principal and interest payments (credit risk), changes in interest rates (interest rate risk), the creditworthiness of the issuer and general market liquidity (market risk). In a rising interest-rate environment, bond prices may fall and may result in periods of volatility and increased portfolio redemptions. In a declining interest-rate environment, the portfolio may generate less income. Longer-term securities may be more sensitive to interest rate changes. Certain U.S. government securities purchased by the strategy, such as those issued by Fannie Mae and Freddie Mac, are not backed by the full faith and credit of the U.S. It is possible that these issuers will not have the funds to meet their payment obligations in the future. Public bank loans are subject to liquidity risk and the credit risks of lower-rated securities. High-yield securities (junk bonds) are lower-rated securities that may have a higher degree of credit and liquidity risk. Sovereign debt securities are subject to default risk. Mortgage- and asset-backed securities are sensitive to early prepayment risk and a higher risk of default, and may be hard to value and difficult to sell (liquidity risk). They are also subject to credit, market and interest rate risks. The currency market is highly volatile. Prices in these markets are influenced by, among other things, changing supply and demand for a particular currency; trade; fiscal, money and domestic or foreign exchange control programs and policies; and changes in domestic and foreign interest rates. Investments in foreign markets entail special risks such as currency, political, economic and market risks. The risks of investing in emerging market countries are greater than the risks generally associated with foreign investments. Derivative instruments may disproportionately increase losses and have a significant impact on performance. They also may be subject to counterparty, liquidity, valuation, correlation and market risks. Restricted and illiquid securities may be more difficult to sell and value than publicly traded securities (liquidity risk).

 
jim.caron
 
Managing Director
 
 
Focus Fund
 
 
 
 
 

DEFINITIONS

Duration is a measure of the sensitivity of the price (the value of principal) of a fixed-income investment to a change in interest rates. Duration is expressed as a number of years. Rising interest rates mean falling bond prices, while declining interest rates mean rising bond prices. Alpha is the excess return or value added (positive or negative) of the portfolio’s return relative to the return of the benchmark. Correlation is a statistical measure of how two securities move in relation to each other.

INDEX DEFINITIONS

The indexes shown in this report are not meant to depict the performance of any specific investment, and the indexes shown do not include any expenses, fees or sales charges, which would lower performance. The indexes shown are unmanaged and should not be considered an investment. It is not possible to invest directly in an index

The Bloomberg Barclays U.S. Aggregate Index tracks the performance of all U.S. government agency and Treasury securities, investment-grade corporate debt securities, agency mortgage-backed securities, asset-backed securities and commercial mortgage-backed securities. The BofA Merrill Lynch 10 Year US Treasury Index measures the performance of U.S. Treasury bonds with at least ten years remaining until maturity. The Bloomberg Barclays U.S. A-rated Corporate Bond Index is an unmanaged index consisting of bonds rated A. The S&P 500® Index (U.S. S&P 500) measures the performance of the large-cap segment of the U.S. equities market, covering approximately 75 percent of the U.S. equities market. The index includes 500 leading companies in leading industries of the U.S. economy.

DISCLOSURES

The views and opinions are those of the author or the investment team as of the date of preparation of this material and are subject to change at any time due to market or economic conditions and may not necessarily come to pass. Furthermore, the views will not be updated or otherwise revised to reflect information that subsequently becomes available or circumstances existing, or changes occurring, after the date of publication. The views expressed do not reflect the opinions of all investment teams at Morgan Stanley Investment Management (MSIM) or the views of the firm as a whole, and may not be reflected in all the strategies and products that the Firm offers.

Certain information herein is based on data obtained from third party sources believed to be reliable. However, we have not verified this information, and we make no representations whatsoever as to its accuracy or completeness.

This material is a general communication, which is not impartial and all information provided has been prepared solely for informational and educational purposes and does not constitute an offer or a recommendation to buy or sell any particular security or to adopt any specific investment strategy. The information herein has not been based on a consideration of any individual investor circumstances and is not investment advice, nor should it be construed in any way as tax, accounting, legal or regulatory advice. To that end, investors should seek independent legal and financial advice, including advice as to tax consequences, before making any investment decision.

This communication is not a product of Morgan Stanley’s Research Department and should not be regarded as a research recommendation. The information contained herein has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is not subject to any prohibition on dealing ahead of the dissemination of investment research.

DISTRIBUTION

This communication is only intended for and will only be distributed to persons resident in jurisdictions where such distribution or availability would not be contrary to local laws or regulations.

There is no guarantee that any investment strategy will work under all market conditions, and each investor should evaluate their ability to invest for the long-term, especially during periods of downturn in the market.  Prior to investing, investors should carefully review the strategy’s / product’s relevant offering document. There are important differences in how the strategy is carried out in each of the investment vehicles.

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U.S.

A separately managed account may not be suitable for all investors. Separate accounts managed according to the strategy include a number of securities and will not necessarily track the performance of any index. Please consider the investment objectives, risks and fees of the strategy carefully before investing. A minimum asset level is required. For important information about the investment manager, please refer to Form ADV Part 2.

Please consider the investment objectives, risks, charges and expenses of the funds carefully before investing. The prospectuses contain this and other information about the funds. To obtain a prospectus please download one at morganstanley.com/im or call 1-800-548-7786. Please read the prospectus carefully before investing.

Morgan Stanley Distribution, Inc. serves as the distributor for Morgan Stanley Funds.

NOT FDIC INSURED | OFFER NO BANK GUARANTEE | MAY LOSE VALUE | NOT INSURED BY ANY FEDERAL GOVERNMENT AGENCY | NOT A BANK DEPOSIT

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IMPORTANT INFORMATION

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MSIM has not authorised financial intermediaries to use and to distribute this document, unless such use and distribution is made in accordance with applicable law and regulation. Additionally, financial intermediaries are required to satisfy themselves that the information in this document is suitable for any person to whom they provide this document in view of that person’s circumstances and purpose. MSIM shall not be liable for, and accepts no liability for, the use or misuse of this document by any such financial intermediary.

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The whole or any part of this work may not be reproduced, copied or transmitted or any of its contents disclosed to third parties without MSIM’s express written consent. All information contained herein is proprietary and is protected under copyright law.

All information contained herein is proprietary and is protected under copyright law.

Morgan Stanley Investment Management is the asset management division of Morgan Stanley.

 

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