FolioBeyond Fixed Income Commentary for October 2021
Performance Summary
FolioBeyond's algorithmic Fixed Income strategy was marginally negative in October, returning -0.07% and -0.03% in its dynamic and static volatility versions, respectively. Year-to-date, the strategies continued their outperformance versus the Bloomberg Barclays U.S. Aggregate Bond Index ("AGG"), by 198 to 262 bps.
The significant moves in Treasury yields were concentrated in the short to intermediate sectors, where both the 2-year and 5-year yields rose by 20 bps. The yield curve flattened as the 10-year yield was only up marginally.
Highlight: Break-Even Rate Shift
In higher interest rate environments years ago, current income from higher coupon rates provided a good cushion against mark-to-market losses from price declines. In contrast, the current environment is characterized by not only near historic lows in interest rates but also narrow credit spreads. Furthermore, we might be at an inflection point in the economic and rate cycle where the long-term bull market takes a sharp turn. With this backdrop, it is helpful to evaluate the risks facing fixed income investors from rate moves on a total return basis.
The table below summarizes the yield levels for a number of representative Fixed Income sector ETFs. The adjusted yield numbers represent the projected income numbers after pricing out the embedded credit and option costs in each sector. By using the individual sector’s duration measures, we show the break-even (“BE”) rate increases that will lead to enough of a price decline to completely offset one year’s worth of interest income. On long duration corporate bonds (IGLB), the BE rate increase is only 19 basis points. This can come about from Treasury rates going up or a combination of a Treasury rates increasing plus spread widening. On long duration Treasuries (TLT), the BE rate increase is only 10 basis points.
Comparison of Break-Even Rate Increases (Data as of 10/29/21)
The above analysis demonstrates that there is not a lot of room for error in producing positive returns from fixed income portfolios over a 1-year holding period. Over a 6-month holding period, the BE numbers would only be half of what is shown in the table.
Portfolio overlays that reduce duration risk while providing some current income are good strategies to consider in the current environment. MBS Interest Only Strips are one type of instrument that provide this kind of profile. This can be implemented directly or by using an ETF.
Please contact us to explore how different overlay strategies can work in managing your fixed income exposure in the current environment. Our fixed income optimization model can further be utilized to specify duration targets and other constraints.
As a reminder, our multisector fixed income model portfolios are available on Goldman Sach’s Folio Institutional platform and Boutique Exchange. It is also available as the S-Network FolioBeyond Optimized Fixed Income Index on SMArtX and C8 Technologies. Our algorithm can also be customized and linked to other custodian platforms.
