What the market took away in the last two weeks of January it gave back in February. Despite latest economic reports expecting weak future growth the S&P 500 returned 4.57% in February negating January’s 3.46% decline. In foreign stock markets, the overall tone was positive. The MSCI EAFE index returned 5.56%.The MSCI Emerging Market index returned 3.19%.
In bond trading the yield on the 10―year U.S.Treasury note ended the month at 2.65% with the benchmark index returning 0.39% MTD and 3.94% YTD. Investment-Grade, Tax-Exempt bonds as tracked by the S&P National AMT-Free Municipal Bond index returned 1.13% bringing YTD returns on the index to 3.28%. Despite uncertainty surrounding the commonwealth, Puerto Rico General Obligation bonds finished the period up 11.57% YTD due to anticipation of a $3 billion deal planned for March designed to stabilize the territory. In the commercial credit markets, the S&P U.S. Investment Grade Corporate Bond index returned 0.91% MTD and 2.86% YTD. In comparison, the S&P High Yield Corporate Bond Index outperformed the Investment Grade index with a 1.92% MTD return. 1.92%. However, the Investment Grade index outpaced the High Yield index on YTD returns. Finally, rising U.S. inflation expectations boosted returns on Inflation Protected Securities 0.45% MTD and 2.43% YTD.
Global Real Estate securities had a good month. The Dow Jones U.S. Select REIT index returned 5.12% MTD bringing returns on the REIT index to 9.39% YTD, significantly outpacing the broader U.S. equity market. The S&P Developed Ex―U.S. REIT index returned 5.54% MTD.. The DJ AIG commodity index returned 6.55%, Gold was up 6.60% and Silver increased 10.90%.
All Things Fixed Income
With yields on investment grade fixed income securities at rock bottom levels and yields on junk bond securities near record lows, some advisors are recommending alternatives such as loans, mortgage backed securities, royalty flows and privately structured streams of receivables among others as means to increase yield from their fixed income allocations. As for investors, some are becoming increasingly relaxed about owning these more volatile asset classes. While defaults within these alternative sectors remain low, peril always lurks and the risk of loss when the credit cycle changes is great. If everyone tried to get out of alternative corners of the market at the same time, the reach for yield could prove deadly.
The role of fixed income in a portfolio will vary according to each investor’s priorities. Whether a strategy is designed to minimize volatility, preserve liquidity, create expected return, generate income, preserve purchasing power, or minimize taxes, the low current level of interest rates suggests that forward returns could remain significantly lower than they have been historically. Low interest rates also significantly increase the possibility of realizing negative returns for fixed income allocations in the short―term. With this in mind, investors are encouraged to view fixed income securities as a diversifier for the riskier assets in their portfolios.
For striking the right balance of fixed income components in a challenging environment the following notes may prove useful: 1) The worst 12―month return for bonds has not come close to what would qualify as a bear market for stocks. 2) Investment―grade bonds are among the best diversifiers of equity risk. 3) Shortening maturities may help protect principal but could lower income. 4) When reaching for yield the main determinants of expected return are the overall maturity and credit quality of the portfolio. 5) Costs Matter. Investors typically do not realize that investment related costs determine a large part of a portfolios yield and return. This applies especially to fixed income securities. In fact, research has shown that a bond mutual fund’s expense ratio helps explain much of its net performance ― and funds with the highest expenses tended to have the lowest performance within their peer group.
Finally, if you spent the last five years watching CNBC or reading the Wall Street Journal you lived in a constant state of alarm over the possibility of runaway inflation and rising interest rates. True, the benchmark 10―year U.S. Treasury yield increased more than 115% from July 2012 through September 2013. While this is the greatest cyclical increase from trough to peak in the last 50 years no one really knows when and by how much interest rates will change from where they are today. Even if interest rates continue to rise, what ultimately matters to most investors is the return of the total portfolio, not just the returns of the fixed income portion of the portfolio. Despite current conditions and the higher than normal chances of fixed income losses, fixed income securities are likely to remain one of the best diversifiers of equity market risk and will likely provide downside protection to balanced investors over the long run. Most investors will be best served by building a fixed income strategy to complement their broader portfolio objectives, understanding the sources of risk and expected return, and paying attention to fees.