Bonds Down Bigly. What To Do With Fixed Income?
April 12, 2022 — The U.S. bond index is down -7.2% year-to-date, its worst start to a year on record.
Currently, bond investors face several challenges.
First, beginning from a near-record low yield did not leave much on the table for investors, and left fixed income allocators with a deck stacked against them. Any slight uptick in yields would leave bond investors with significant losses.
Second, a double-digit increase in the money supply, driven by a massive surge in government spending over the past two years, created a potential nasty bout of persistent inflation.
The market has digested six consecutive monthly increases in the annual inflation rate. The yearly change in the consumer price index is forecast to peak at 8.5% and average more than 5.0% in 2022.
Bond investors priced the U.S. 10-year Treasury yield at 1.6% to start the year and have suffered as the yield has risen to 2.7%. However, with an upcoming inflation print likely above 8.0%, it is not difficult to envision that yield rising above 3.0% and higher.
Source: Marketwatch, Accelerate
For bond investors, the trend is not your friend.
Investors often say, “don’t fight the Fed”. Consistent with that dogma, let’s examine what the U.S. central bank is forecast to accomplish this year.
The market is forecasting an aggressive rate hiking cycle from the Fed this year, with 50 bps rate hikes in May, June and possibly July. As a result, the overnight rate is expected to reach 2.5% by year-end.
After a rough start to the year, fixed-income investors are likely to face more pain as significant headwinds remain.
In addition, equity investors face several salient risks.
Specifically, stock investors face drawdown potential due to valuation and recession risk.
Historically, high inflation has been negative for equity investors.
According to BofA quant research, a forecast CPI annual increase of 7.5% for 2022 implies the S&P 500 trading at 12x earnings. Unfortunately for equity investors, the S&P 500 is currently trading above 20x this year’s forecast earnings.
With a series of rapid rate hikes set for this year, many market participants are concerned regarding a potential Fed policy error. Market participants believe that the central bank’s aggressive rate hiking cycle, needed to fight out-of-control inflation, may put the economy into recession.
Source: Accelerate, Deutsche Bank
The 2s10s yield spread is the most accurate recession forecaster that we have. The yield curve has predicted the past seven recessions. The recession alarm just sounded as the yield curve recently inverted. Historically, a recession has occurred 6–18 months after a yield curve inversion, and recessions are typically ugly for equity investors.
With a unique set of risks facing both fixed income and equity investors, what is a capital allocator to do?
Thankfully, there are alternatives.
According to JPMorgan, taking the traditional 60/40 stock/bond portfolio and substituting a 30% allocation to alternative investments dramatically increased an investor’s portfolio risk/return profile over the past twenty+ years.
Since 1989, the traditional 60/40 portfolio has attained an annual return of 9.0% with a volatility of 9.3%. In contrast, the more diversified 40/30/30 portfolio (including a 30% alternatives allocation) had an annual return of 9.5% with a volatility of 7.8%.
Historically, utilizing a 40% stock, 30% bond, and 30% alternatives portfolio resulted in a 50 bps increase in return and a -17% decrease in risk.
Diversifying investor portfolios by including alternative investments has historically increased portfolio returns while decreasing risk. Given the risks facing bond and stock investors in the current market environment, decreasing risk through diversification may be prescient.
Accelerate manages five alternative ETFs, each with a specific mandate:
- Accelerate Arbitrage Fund (TSX: ARB): SPAC and merger arbitrage
- Accelerate Absolute Return Hedge Fund (TSX: HDGE): Long-short equity
- Accelerate OneChoice Alternative Portfolio ETF (TSX; ONEC): Alternatives portfolio solution
- Accelerate Enhanced Canadian Benchmark Alternative Fund (TSX: ATSX): Buffered index
- Accelerate Carbon-Negative Bitcoin ETF (TSX: ABTC): Eco-friendly bitcoin
Please see below for fund performance and manager commentary.
ARB is proving itself as a solid yield generator in a rising rate environment as the strategy was up 0.5% in March when yields surged and bonds plummeted.
As of month-end, 97.6% of SPACs were trading at a discount to NAV (remember, SPACs represent discount U.S. T-bills). The total aggregate SPAC arbitrage profit pool, representing the difference between their redeemable NAVs and market prices, is $4.0 billion.
Despite extreme negative sentiment in the SPAC market, new issuance continues with 9 blank check IPOs in March raising an aggregate of $1.3 billion. 12 business combinations were announced throughout the month, while 8 closed and 1 SPAC liquidated. Negative sentiment in the market created the $4 billion profit pool available to SPAC arbitrageurs, so who’s complaining?
Despite equity and bond market volatility, the M&A market is on fire with nearly $500 billion of outstanding transactions. Private equity has come back to the market aggressively, announcing large multibillion buyouts in the face of geopolitical and market uncertainty. Nearly 20% of the deals announced in March were leveraged buyouts. Given the unpredictability of the current U.S antitrust regulatory regime, private equity buyouts may be an excellent place to allocate merger arbitrage capital given their lower regulatory risk.
Given the massive risk of rapidly rising yields, ARB has a very low duration of just 5.2 months, meaning it can rapidly adapt to a much higher interest rate regime without investors taking much of a hit.
HDGE declined -1.2% during March as the S&P 500 rallied.
Historically, HDGE has had a slightly negative correlation to equities, although, with a correlation of just -0.03, it is seemingly as close to uncorrelated as you can get.
In any event, when low-quality “junk stocks” surge, HDGE typically does poorly given its ~50% short portfolio of money-losing companies.
A junk-stock rally in March led to the HDGE decline for the month. The long-short quality portfolio was down -6.6% in the U.S. given the gain in low-quality equities. The loss was slightly offset by positive alpha from long-short operating momentum and trend.
If investors want a portfolio hedge, they may want to consider long-short equity over put options, because put options are costly (and have negative expected value). Given that long-short equity has had a positive since inception return with a negative correlation to the equity index, it may be viewed as market insurance that you are paid to own.
ONEC gained 1.1% in March, with positive performance led by bitcoin’s 8.6% surge. The Fund’s real asset strategies, infrastructure and real estate, were up 5.6% and 3.7%, respectively. Arbitrage and enhanced equity were also positive contributors, increasing by 0.5% and 3.9%.
Several alternative strategies contributed negatively. The alternative credit allocations, leveraged loans and mortgages, fell by -0.2% and -2.1%, respectively. In addition, long-short equity was down -1.3% while risk parity declined by -0.9%.
Since its inception, ONEC has generated a 10.1% annualized return with a Sharpe ratio above 1.0 and a correlation to the equity market of just 0.4. ONEC is tracking slightly above the model’s expectations.
ATSX gained 3.9% in March, slightly ahead of its benchmark, the TSX 60, which had a 3.8% return.
The long-short buffer portfolio in the Fund added 10 bps to the monthly performance. Although results were mixed, Canadian long-short multifactor performance was positive in the month. Long-short trend and price momentum produced positive alpha, offset by declines in long-short value, operating momentum and quality.
Since its inception, ATSX has outperformed its benchmark, the TSX 60, with a downside capture of 0.9. The majority of the Fund’s outperformance has occurred during equity market drawdowns, given the mechanics of the buffer portfolio. As it approaches its 3-year track record in May, ATSX has been tracking our high expectations and proving the model for index investors who want mitigated downside combined with upside participation.
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Disclaimer: This distribution does not constitute investment, legal or tax advice. Data provided in this distribution should not be viewed as a recommendation or solicitation of an offer to buy or sell any securities or investment strategies. The information in this distribution is based on current market conditions and may fluctuate and change in the future. No representation or warranty, expressed or implied, is made on behalf of Accelerate Financial Technologies Inc. (“Accelerate”) as to the accuracy or completeness of the information contained herein. Accelerate does not accept any liability for any direct, indirect or consequential loss or damage suffered by any person as a result of relying on all or any part of this research and any liability is expressly disclaimed. Past performance is not indicative of future results. Visit www.AccelerateShares.com for more information.