The Great Debate on the Great Rotation: The Fixed Income Perspective
There have been many classic debates in popular culture over the years. In technology we’ve had PCs versus Mac, and then Droid versus iPhone. In beverages, we’ve had Coke versus Pepsi, while in entertainment we’ve suffered through Team Edward versus Team Jacob. And baseball will always have the Red Sox versus the Yankees. Even in investments, we have had our own ongoing version of a great debate, which has been simmering for a few years, yet this one involves asset allocation and is much more meaningful and significant: will there be a “great rotation” out of corporate bonds into equities?
Over the past few months, as I have interacted with clients globally, no matter where the conversation starts, it will inevitably end up at this vital debate of the post-crisis era. When will the great rotation out of fixed income and into equities happen? Is it happening now? What will it look like? Is that the biggest risk to fixed income on the horizon? Are corporate bonds the next bubble?
Lets’ tackle these important questions:
- What does the “great rotation” mean and what will it look like? Since the end of 1981, because of then-Fed chairman Paul Volker’s paradigm shift on inflation-fighting tactics, 10-year interest rates have declined from 14% to less than 2%. This move in rates has overpowered the move in credit spreads, resulting in an average annual total return on U.S. investment grade corporate bonds of around 10% over the last 30 years. Conversely, average annual returns on equities have averaged around 12%, only 200 basis points higher, over the same time period – but they’ve had twice the volatility of corporate bonds. With historically low interest rates, the fear is that when interest rates start increasing again, and the total-return losses in bond portfolios will force investors to sell bond holdings in favor of equities (as rising rates are signaling stronger economic times). Although this may be a valid application of rational investor theory, the demographic demands of the retiring baby-boom generation (in need of capital preservation, lower volatility, and income) combined with a shrinking investable opportunity set (because of central bank purchases of government and mortgage debt) are strong forces against any large rotations out of corporate bonds.
- With equities near all-time highs, is it happening now? Quite simply, no. Not only are outflows from bond funds not occurring, inflows to high-grade corporate bond funds are extremely strong. There has been 13 consecutive weeks of inflows, with $2.4 billion this week alone. The first quarter of 2013 has been just as strong as the first quarter 2012. The rotation that IS happening is out of cash (and thus into equities and corporate bonds), because money market funds have had outflows of $43 billion year to date in addition to $151 billion for all of 2012. This is exactly the behavior the Federal Reserve and other global central banks have wanted as a result of quantitative easing – increased purchases of risky assets.
- Will it happen soon? Absolute declarations are never wise, but a great rotation in 2013 is not imminent. Bond investors have yet to suffer their first total-return loss post-crisis and any asset allocation change will lag the realization of negative nominal returns. In addition, many investors will continue to be forced to have a large allocation to bonds because of their liability considerations and demographic necessities. We have also just begun to witness “re-balancing” trades – increasing flows into bonds from equities – given the recent strong performance of equity markets. Additional mini-bursts of systemic risk (e.g., Cyprus, Iran, North Korea) coupled with the sputtering global growth environment will moderate any rate increase. These conditions allow global central banks to continue their coordinated easing policies, helping to prevent large-scale total-return losses for bonds.
- Are corporate bonds the next bubble? This question is deserving of its own separate discussion, but the short answer is “no.” For those more probability-minded, think along the lines of the Chicago Cubs winning the World Series. For investors to be appropriately compensated for just the default risk inherent in an investment grade corporate bond, one would have to be paid 30-40 basis points (1 basis point = 0.01%) above the prevailing Treasury yield – that is, the supposed risk-free rate. Investors are currently earning more than 130 basis points over comparable U.S. Treasurys. That type of value proposition is not reflective of a bubble. In addition, classic supply-demand forces point to an increasing demand for corporate bonds (as investors are forced out of holding Treasurys and cash by quantitative easing) while net supply of risk assets (investment grade, high yield, ABS, MBS, etc. as a whole) continues to shrink. The “crowding out” effect of central banks’ quantitative easing makes this environment more supportive for corporate bonds than in many historical environments. In virtually all historical periods of rising rates driven by improved growth expectations and reduced market fear, the risk premium of corporate bonds has fallen. We don’t expect this time to be any different.
Like all great debates, this one will continue, with many passionate participants from each side claiming how they are winning each battle. Our concern will continue to be on winning the larger skirmish of providing the best risk-adjusted returns to our clients over the intermediate and long-terms and through multiple market cycles. And if we can do all of that while writing to you on a Mac and sipping a Pepsi, well then all the better.