By Evan Witkowski, CIPM
   Manager, Institutional Relationships
 
   

 

Investing in fixed income assets like bonds is a very popular strategy that is often considered a relative safe haven for investors. But the market has been quite volatile in recent years, and this strategy looks a lot different today compared to the low interest rate environment seen just a few years ago. Many investors are understandably re-evaluating their approach to bonds right now, weighing both their risks and their historic opportunities.

With all this in mind, members of the Wespath team have developed a three-part series on bond investing to share their thoughts on fixed income opportunities and how Wespath approaches these types of investments.

Part one of this series, “Exploring the Fixed Income Market,” is available here. Part two, “Exploring the Private Credit Market,” is available here.

In recent weeks, my colleagues Connie and Piotr have shared some interesting analyses of the fixed income market, covering everything from the Federal Reserve’s rapid rate hiking cycle to the multi-year highs in bond yields and the unique opportunities to be found in private credit. One common theme of both their commentaries was the value of incorporating these investment opportunities within a diversified fund or portfolio. That’s what I’d like to zoom in on in the final part of our fixed income series!

Connie provided a lot of background on the challenges that adversely affected the bond market in 2022. To me, this period likely underscored for many the risks of “bond picking,” or trying to time markets by purchasing a few individual bonds.

Bond picking is much more complicated than it may seem. Investors must consider many factors, including the credit quality of the bond issuer, the ease of selling a bond should the investor require cash for other purposes and the risk that a bond’s market value will decrease due to rising interest rates. Just a reminder, when interest rates (and bond yields) go up, bond prices go down.

Investors who pick an undiversified selection of bonds without professional advice risk incurring meaningful losses should interest rate and/or credit conditions adversely change. Even now, with inflation tempering and yields sitting at elevated levels, trying to select individual bonds that might deliver exceptional performance would require expertise and time that most investors and investment committees simply don’t have.

Nevertheless, few investors were spared the significant losses that ensnarled fixed income markets last year—whether they were selecting individual bonds or investing in diversified bond funds. So, why should investors consider a diversified approach to bond investing after all?

First, let’s run through a quick primer on how and when bonds—often thought of as a “safe” investment—can disappoint investors.

Why Simpler Is Better

My colleagues aptly explained the inverse relationship between bond prices and interest rates, which underscores why the fixed income market has been volatile in recent years. There are some other factors to consider as well—namely the costs involved with buying individual bonds. U.S. Treasury bonds and bills can be purchased online through TreasuryDirect for no fees or commissions, but in most other cases, investors rely on a brokerage firm to buy bonds. These firms may require account minimums, will charge service fees and commissions, and usually offer bonds at higher price to small investors who cannot afford to purchase “round lot” amounts of $1 million or more. This can make buying individual bonds impractical for most individual investors, even if we put aside the challenge of trying to find the right bonds in a volatile market.

I work closely with many of our Methodist institutional investors and have seen many different approaches to bond investing in the institutional investing world. Some organizations like to maintain close control over their investment decisions and may prefer to delegate final decision-making to their investment committees. Some investment committees may delegate this to the organization’s staff or hire a professional adviser to purchase individual bonds. However, a more efficient and practical approach would be to consider investing in diversified bond/fixed income funds rather than purchasing individual bonds. Perhaps the recommendation for such an approach seems obvious coming from Wespath, where we state a “Diversified, Long-Term Perspective” as one of our five core Investment Beliefs.

Wespath’s Approach

Earlier in our fixed income series, you read about both traditional fixed income investments and private credit as elements of Wespath’s Fixed Income Fund – P Series (for participants and plan sponsors) and Fixed Income – I Series (for institutional investors). These are diversified fixed income funds that offer exposure to a variety of types of bonds such as:

• Corporate bonds, both investment grade and below investment grade
• Structured debt, including asset backed securities (sometimes abbreviated as ABS), commercial mortgage-backed securities (CMBS), and mortgage-backed securities (MBS)
• Emerging market debt
• Government debt, including sovereign bonds

The idea with these and other diversified bond funds is to take out a lot of the guesswork and provide a range of bond exposure in an easy-to-access format.

An important element of our fixed income funds is that they incorporate different types of strategies managed by external asset managers skilled at analyzing specific areas of the fixed income market. By taking this approach, our participants and investors can take advantage of industry professionals—the people who have the expertise and time to identify the best individual bonds, and then keep tabs on the bond issuers’ financial health—without all the logistical headaches. Both of these funds also invest in loan participations through our Positive Social Purpose Lending Program, so participants and investors get exposure to positive impact investing that supports things like affordable housing, all with the goal of receiving a market rate investment return.

Another way to understand the value provided by Wespath’s external asset managers is to compare actively managed bond funds with passively managed bond funds designed to mirror an index. With bond index funds, the makeup of the fund is limited to that of the index. For example, the widely used Bloomberg U.S. Aggregate Index has a roughly 40% allocation to U.S. Treasury bonds—it was less than 30% before the 2008 Great Recession—and indexed strategies must accept those sector weightings regardless of one’s outlook.¹ The U.S. Treasury component will likely increase given expanding federal deficits, and that will limit return opportunities for a bond index fund compared to an actively managed portfolio that is comprised of high quality entities and not encumbered by shifting composition of the index.

One additional advantage of bond funds with daily pricing, like the Wespath funds, is that they offer daily liquidity, making it very easy to access cash. Individual bonds have varying degrees of liquidity. Liquidity depends on several factors and can decrease dramatically during periods of market stress, such as we witnessed in March 2020 during the COVID pandemic. If an investor is forced to sell a holding, the investor may have to accept a lower price. This is akin to a homeowner who must quickly relocate: As a forced seller, the homeowner may have to accept a lower price in order to access cash quickly to purchase a new home somewhere else. To be clear, bond funds include bonds that are subject to varying liquidity. However, the underlying asset managers can typically provide liquidity because of the diversity of holdings within the fund. The asset managers have the option to sell more liquid securities if cash is needed in the short term.

Another factor to consider is that Wespath offers several different types of fixed income funds. In addition to those named above, we maintain funds focused on inflation protection, capital preservation, shorter-term fixed income opportunities and more. Investors should be thinking about how various types of funds can help them achieve their goals while protecting them against different risks. As my colleagues have noted, it’s clearly an opportune moment for fixed income overall, so you may want to consider a strategy that could work best for you.

¹ https://www.callan.com/blog-archive/aggregate-changes/ and https://www.blackrock.com/us/individual/products/239458/ishares-core-total-us-bond-market-etf