Viewpoints

Is the Role of Bonds Changing in the Face of Low Yields?

Despite historically low yields, we believe fixed income remains essential in portfolios, perhaps now more than ever. In fact, as our case study explains, active bond management continues to offer potential for alpha generation and risk mitigation.

More from this section

Read Transcript

Text on screen: PIMCO

Footer Overlay: PIMCO provides services only to qualified institutions and investors. This is not an offer to any person in any jurisdiction where unlawful or unauthorized.

Text on screen: Josh Davis, Global Head of Client Analytics

Davis: I think this is certainly a very interesting time for many investors. I mean we haven't seen bond yields this low pretty much in modern history. That said, we've certainly seen it in the case of Japan Germany, which we'll discuss in a moment.

But what we wanted to do is take a deep dive into this whole topic of the role of fixed income and try to really ascertain the relevance of fixed income in portfolios going forward.

Text on screen: 1. Fixed income: a time-tested diversifier to equities

I think the most important reason why investors allocate to fixed income is because of the fact that they seem to offer ballast in a portfolio.

That is to say that they offer very different risks than what's embedded in equities, and equities are clearly the most dominant risk in portfolios. Fixed income traditionally, at least over the last 20 or so years, has delivered a very negative correlation with that of equities.

Full page graphic: Line chart titled, “Stock-bond correlation in the U.S.” plots the up and down correlation between stocks and bonds in the U.S. since 1933. The line declines (less correlation) more over the last 20 years versus the prior periods since 1933.

When we actually take a look at fixed income historically, we think this is actually a very critical factor. The defensive nature of fixed income in portfolios is incredibly important.

It isn't only reliant on the stock-bond correlation being negative on average. In fact if we look at nine out of the last ten recessions, many of those recessions corresponding to periods where the stock-bond correlation was actually positive, bonds consistently delivered positive performance.

So we think that defensive nature in fixed income is extremely important, and certainly with yields today at around 1.5% on the U.S. 10-year, they're much more defensive than they were at 50 basis points. The further you are from the zero lower bound, certainly the more that fixed income will display these defensive characteristics.

But of course that's not the only story. It goes much deeper than that.

Full page graphic: The text chart titled, “Fundamentals of fixed income” compares macro fundamentals (demographics, productivity, inequality, preferences, inflation, monetary policy, bond market net supply), their trends and impact, and their net impact on rates. All have a lower impact on rates except inflation, which is higher.

As we move on to the fundamentals in fixed income and we take a look at what's driving real bond yields, it's many of these macro trends that we don't think will change any time soon. Things like demographics—as agents age in the economy they certainly need to save more—creates a bid for fixed income.

Other factors, like the COVID scenario, which change preferences of many agents, that results in a bid for fixed income as many try to actually build up their savings and rainy-day fund to combat these sorts of severe scenarios.

When we actually take a look at valuations that's also quite interesting. Many would think that naturally equities would be the pivot in a portfolio to pursue, as bond yields offer less in terms of return, but that, of course, isn't the whole story.

When we look at valuation models it actually says something very interesting. First and foremost, the relative value of equities to bonds—so when we look at the earnings yield on equities and we compare that to the real bond yield—that is actually in a very sort of suppressed state. We'd expect, therefore, bonds to be quite cheap relative to equities, kind of in opposite to what many think.

Text on screen: 2. Yields alone don’t necessarily reflect total return

I want to talk a little bit more about bond yields, because bond yields don't tell the whole story. In particular, when yields are low there's this kind of interesting thing that's happened in places like Japan and Germany.

Full page graphic: The bar chart titled, “Annual returns of 10-year JGBs and 12-month Libor” compares the annual rate of return for the 12-month Libor versus the 10-year JGB since 1999. Since 1999, the 10-year JGB has had high returns at the start of the series to more modest returns moving negative in 2003 ands also during the past 2 years. The 12-month Libor has seen more modest returns with slight increases over the course of the period, always staying positive.

So what we did is we took a look at Japan going back to around 1998 when bond yields have been sub-2% ever since, and tried to kind of decompose and understand why the returns have been so high.

They've been far in excess of cash, and in fact the bond returns in Japan, looking at, for example, the 10-year Japanese government bond, has delivered somewhere on the order of 3x the Sharpe ratio of equities. There I'm kind of referencing the NIKKEI Index as the relative equity investment.

When we take a look at Germany we see the same sort of thing unfold. German bunds—so the 10-year German bond—has been sub-1% yield since around 2014, and there that bund sort of return has delivered around 3x the Sharpe ratio of what we've seen in German equities, as evidenced by the DAX.

So there's this question of why the Sharpe ratio has been so high. Part of that, of course, is due to the denominator effect, the fact that risk has been lower. As yields drop, volatility has dropped as well. But that's not the whole story, as much of it is packed in the numerator, the fact that there has been an excess return above cash that's been significant.

So when you actually try to understand what's going on, you see that bond yields don't tell the whole story. Actually, the term premium tells you a lot around the excess return in bonds. So the steepness of the curve matters.

Just to kind of think of it, if you buy a ten-year bond and you hold it for one year and sell it as a nine-year bond and reinvest in a ten-year, not only are you getting the yield on that bond for that one-year holding period, but you're also getting the fact that you're rolling down the curve, and the term structure may be steep.

And so that explains a lot about the excess return on Japanese government bonds and German bunds. And interestingly enough today, if we take a look at the steepness of the U.S. yield curve, it's quite steep. So the difference between the two- and the ten-year yield is on the order of 120 basis points.

And when you look at that compared to what was realized historically in Japan, the average curve steepness in Japan was only about 90 basis points.

Text on screen: 3. Fixed income alpha has offered consistency

Full page graphic: The bar chart titled, “10-year active versus passive fund performance” compares Morningstar categories with the probability of outperformance over median passive peers and the 10-year average returns. High yield bond category has the highest probaiblity of outperformance over median passive peer (76%), followed by intermediate core bond (66%), short-term bond (44%), large growth (15%), large blend (8%) and large value (24%).

Active management, or the delivery of alpha, in bond portfolios seems to be quite consistent and substantial. We took a look at the Morningstar database and analyzed all bond managers in that database, as well as equity managers, and found that story to really play out.

Equities, for whatever reason, active management has not really been rewarded over the past 10 to 20 years, whereas in bonds it's been consistently sort of rewarded. Insofar as alpha is incredibly important, as beta returns have been somewhat constrained going forward, active management would seem to offer a key opportunity.

Finally, we want to mention that inflation is the fly in the ointment here. We haven't discussed inflation much, and should we go through a big inflationary episode that would certainly be negative for bonds. So we'd certainly point the interested sort of client in that direction as something to investigate.

Text on screen: For more insights and information visit pimco.com

Full page graphic: PIMCO 50, 1971 to 2021

Disclosure


IMPORTANT NOTICE

Please note that the following contains the opinions of the manager as of the date noted and may not have been updated to reflect real time market developments. All opinions are subject to change without notice.

Past performance is not a guarantee or a reliable indicator of future results.

All investments contain risk and may lose value. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and low interest rate environments increase this risk. Reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Investing in foreign-denominated and/or -domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. Sovereign securities are generally backed by the issuing government. Obligations of U.S. government agencies and authorities are supported by varying degrees, but are generally not backed by the full faith of the U.S. government. Portfolios that invest in such securities are not guaranteed and will fluctuate in value. Inflation-linked bonds (ILBs) issued by a government are fixed income securities whose principal value is periodically adjusted according to the rate of inflation; ILBs decline in value when real interest rates rise. Equities may decline in value due to both real and perceived general market, economic and industry conditions.

Management risk is the risk that the investment techniques and risk analyses applied by investment advisor will not produce the desired results, and that certain policies or developments may affect the investment techniques available to the advisor in connection with managing the strategy.

Correlation is a statistical measure of how two securities move in relation to each other. The correlation of various indexes or securities against one another or against inflation is based upon data over a certain time period. These correlations may vary substantially in the future or over different time periods that can result in greater volatility.

The Sharpe Ratio measures the risk-adjusted performance. The risk-free rate is subtracted from the rate of return for a portfolio and the result is divided by the standard deviation of the portfolio returns. Standard deviation is a measure of the dispersion of a set of data from its mean. The more spread apart the data, the higher the deviation.

Roll-down is a form of return that is realized as a bond approaches maturity, assuming an upward sloping yield curve.

Alpha is a measure of performance on a risk-adjusted basis calculated by comparing the volatility (price risk) of a portfolio vs. its risk-adjusted performance to a benchmark index; the excess return relative to the benchmark is alpha. Beta is a measure of price sensitivity to market movements. Market beta is 1.

The terms “cheap” and “rich” as used herein generally refer to a security or asset class that is deemed to be substantially under- or overpriced compared to both its historical average as well as to the investment manager’s future expectations. There is no guarantee of future results or that a security’s valuation will ensure a profit or protect against a loss.

Charts are provided for illustrative purposes and are not indicative of the past or future performance of any PIMCO product.

Statements concerning financial market trends or portfolio strategies are based on current market conditions, which will fluctuate. There is no guarantee that these investment strategies will work under all market conditions or are appropriate for all investors and each investor should evaluate their ability to invest for the long term, especially during periods of downturn in the market. Outlook and strategies are subject to change without notice.

This material contains the opinions of the manager and such opinions are subject to change without notice. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.

PIMCO as a general matter provides services to qualified institutions, financial intermediaries and institutional investors. Individual investors should contact their own financial professional to determine the most appropriate investment options for their financial situation. This is not an offer to any person in any jurisdiction where unlawful or unauthorized. | Pacific Investment Management Company LLC, 650 Newport Center Drive, Newport Beach, CA 92660 is regulated by the United States Securities and Exchange Commission. | PIMCO Europe Ltd (Company No. 2604517) is authorised and regulated by the Financial Conduct Authority (12 Endeavour Square, London E20 1JN) in the UK. The services provided by PIMCO Europe Ltd are not available to retail investors, who should not rely on this communication but contact their financial adviser. | PIMCO Europe GmbH (Company No. 192083, Seidlstr. 24-24a, 80335 Munich, Germany), PIMCO Europe GmbH Italian Branch (Company No. 10005170963), PIMCO Europe GmbH Spanish Branch (N.I.F. W2765338E) and PIMCO Europe GmbH Irish Branch (Company No. 909462) are authorised and regulated by the German Federal Financial Supervisory Authority (BaFin) (Marie- Curie-Str. 24-28, 60439 Frankfurt am Main) in Germany in accordance with Section 32 of the German Banking Act (KWG). The Italian Branch, Irish Branch and Spanish Branch are additionally supervised by: (1) Italian Branch: the Commissione Nazionale per le Società e la Borsa (CONSOB) in accordance with Article 27 of the Italian Consolidated Financial Act; (2) Irish Branch: the Central Bank of Ireland in accordance with Regulation 43 of the European Union (Markets in Financial Instruments) Regulations 2017, as amended; and (3) Spanish Branch: the Comisión Nacional del Mercado de Valores (CNMV) in accordance with obligations stipulated in articles 168 and  203  to 224, as well as obligations contained in Tile V, Section I of the Law on the Securities Market (LSM) and in articles 111, 114 and 117 of Royal Decree 217/2008, respectively. The services provided by PIMCO Europe GmbH are available only to professional clients as defined in Section 67 para. 2 German Securities Trading Act (WpHG). They are not available to individual investors, who should not rely on this communication. | PIMCO (Schweiz) GmbH (registered in Switzerland, Company No. CH-020.4.038.582-2) . The services provided by PIMCO (Schweiz) GmbH are not available to retail investors, who should not rely on this communication but contact their financial adviser. | PIMCO Asia Pte Ltd (Registration No. 199804652K) is regulated by the Monetary Authority of Singapore as a holder of a capital markets services licence and an exempt financial adviser. The asset management services and investment products are not available to persons where provision of such services and products is unauthorised. | PIMCO Asia Limited is licensed by the Securities and Futures Commission for Types 1, 4 and 9 regulated activities under the Securities and Futures Ordinance. PIMCO Asia Limited is registered as a cross-border discretionary investment manager with the Financial Supervisory Commission of Korea (Registration No. 08-02-307). The asset management services and investment products are not available to persons where provision of such services and products is unauthorised. | PIMCO Investment Management (Shanghai) Limited Unit 3638-39, Phase II Shanghai IFC, 8 Century Avenue, Pilot Free Trade Zone, Shanghai, 200120, China (Unified social credit code: 91310115MA1K41MU72) is registered with Asset Management Association of China as Private Fund Manager (Registration No. P1071502, Type: Other) | PIMCO Australia Pty Ltd ABN 54 084 280 508, AFSL 246862. This publication has been prepared without taking into account the objectives, financial situation or needs of investors. Before making an investment decision, investors should obtain professional advice and consider whether the information contained herein is appropriate having regard to their objectives, financial situation and needs. | PIMCO Japan Ltd, Financial Instruments Business Registration Number is Director of Kanto Local Finance Bureau (Financial Instruments Firm) No. 382. PIMCO Japan Ltd is a member of Japan Investment Advisers Association and The Investment Trusts Association, Japan. All investments contain risk. There is no guarantee that the principal amount of the investment will be preserved, or that a certain return will be realized; the investment could suffer a loss. All profits and losses incur to the investor. The amounts, maximum amounts and calculation methodologies of each type of fee and expense and their total amounts will vary depending on the investment strategy, the status of investment performance, period of management and outstanding balance of assets and thus such fees and expenses cannot be set forth herein. | PIMCO Taiwan Limited is managed and operated independently. The reference number of business license of the company approved by the competent authority is (109) Jin Guan Tou Gu Xin Zi No. 027. 40F., No.68, Sec. 5, Zhongxiao E. Rd., Xinyi Dist., Taipei City 110, Taiwan (R.O.C.). Tel: +886 2 8729-5500. | PIMCO Canada Corp. (199 Bay Street, Suite 2050, Commerce Court Station, P.O. Box 363, Toronto, ON, M5L 1G2) services and products may only be available in certain provinces or territories of Canada and only through dealers authorized for that purpose. | PIMCO Latin America Av. Brigadeiro Faria Lima 3477, Torre A, 5° andar São Paulo, Brazil 04538-133. | No part of this publication may be reproduced in any form, or referred to in any other publication, without express written permission. PIMCO is a trademark of Allianz Asset Management of America L.P. in the United States and throughout the world. ©2021, PIMCO.

CMR2021-0504-1636513

Filters: Reset All

Filters

Close Filters Dropdown
  • Tags

    Reset

    Close
  • Category

    Reset

    Bond by Bond
    Careers
    Economic and Market Commentary
    Investment Strategies
    PIMCO Foundation
    PIMCO Education
    View from the Investment Committee
    Viewpoints
    Education
    Close
  • Order By

    Reset

    Alphabetical
    Most Recent
    Close
() filters applied

Multimedia Finder

Filter By:
  • Careers
  • Economic and Market Commentary
  • Investment Strategies
  • PIMCO Education
  • View from the Investment Committee
  • Viewpoints
  • Understanding Investing
  • A
  • B
  • C
  • D
  • F
  • G
  • H
  • I
  • K
  • L
  • M
  • N
  • O
  • P
  • R
  • S
  • T
  • W
Clear
Tina Adatia
Fixed Income Strategist
Joshua Anderson
Head of Global ABS Portfolio Management
Andrew Balls
CIO Global Fixed Income
Justin Blesy
Asset Allocation Strategist
David L. Braun
Head of US Financial Institutions Portfolio Management
Nathaniel Brown
Director of the PIMCO Foundation
Erin Browne
Portfolio Manager, Multi-Asset Strategies
Libby Cantrill
Executive Office, Public Policy
Josh Davis
Global Head of Client Analytics
Pramol Dhawan
Head of Emerging Markets Portfolio Management
Joachim Fels
Global Economic Advisor
David Fisher
Co-Head of Strategic Accounts
Nick Granger
Portfolio Manager, Quantitative Analytics
Gregory Hall
Head of U.S. Global Wealth Management
Mary Hoppe
Daniel H. Hyman
Head of Agency MBS Portfolio Management
Daniel J. Ivascyn
Group Chief Investment Officer
Mark R. Kiesel
CIO Global Credit
Christine Long
Head of Retirement Marketing
Scott A. Mather
CIO U.S. Core Strategies
John Murray
Portfolio Manager, Commercial Real Estate
John Nersesian
Head of Advisor Education
Roger Nieves
Senior Advisor
Jason Odom
Strategist, Asset Allocation
Sonali Pier
Portfolio Manager, Multi-Sector Credit
Libby Rodney
Steve A. Rodosky
Portfolio Manager, Real Return and Long Duration
Emmanuel Roman
Chief Executive Officer
Steve Sapra
Client Solutions & Analytics
Jerome M. Schneider
Head of Short-Term Portfolio Management
Marc P. Seidner
CIO Non-traditional Strategies
Greg E. Sharenow
Portfolio Manager, Real Assets
Anmol Sinha
Fixed Income Strategist
Candice Stack
Head of Client Management, Americas
Kimberley Stafford
Global Head of Product Strategy
Cathy Stahl
Global Head of Marketing
Geraldine Sundstrom
Portfolio Manager, Asset Allocation
Eve Tournier
Head of European Credit Portfolio Management
Jerry Tsai
Quantitative Research Analyst
Jamie Weinstein
Portfolio Manager, Head of Corporate Special Situations
Tiffany Wilding
North American Economist
Ben S. Bernanke
Chair, Global Advisory Board
  • Alphabetical
  • Most Recent
Section : Date : Experts :
Reset All
Comparing Risk Assets in Mid-Cycle Markets
Economic and Market Commentary

Comparing Risk Assets in Mid-Cycle Markets(video)

Comparing Risk Assets in Mid-Cycle Markets

Growth-oriented asset classes are likely to shine, but not equally. Geraldine Sundstrom and Erin Browne discuss our views across asset classes, including equities, credits, currencies and rates, and how we’re positioning for a mid-cycle environment.

More from this Asset Allocation Outlook

Mid-Cycle Investing: Growth-Oriented and Selective
Cyclical Outlook: Peak Policy, Peak Inflation, Peak Growth
Implications from our Cyclical Outlook
PIMCO GIS Diversified Income Fund update
Unlocking Alternatives: Possibilities in Quantitative Analytics