Of Stocks and Bonds

SUMMARY

• Long maturity treasuries can provide downside protection to offset equity risk, in our view.
• TIPS can provide a ‘stagflation’ hedge, but we prefer energy equities in a multi-asset portfolio.
• We believe credit investments can enhance the total return of an equity portfolio.

At RiverFront, we like to view fixed income through the lens of multi-asset portfolios. We have previously discussed how understanding fixed income can often be beneficial to valuing equity, in our discounted cash flow (DCF) primer. Beyond equity selection and valuation, we want to discuss how fixed income can be used in portfolio construction, particularly for more equity-oriented portfolios. We believe smaller fixed income allocations, combined with a higher risk tolerance, create opportunities to use certain fixed income building blocks in ways that go beyond just a core allocation. Today’s Weekly View discusses how we view certain fixed income investments within the context of complimenting equity portfolios, specifically focusing on fixed income’s downside protection and total return enhancement.

We Believe Long Treasuries Can Be a Good Recession Hedge

As a starting point, in our 2025 Outlook we do not view a recession as the most likely outcome this year, placing a 20% chance on a ‘bear case’ outcome. With that being said, we believe that properly hedging out portfolios against the potential risk of a negative market outcome is important. In our view, long maturity treasuries (government bonds with maturities longer than 10 years) are an efficient way of accomplishing this hedge. This feature is illustrated in Chart 1, below: while the relationship is not perfect, we can see that when US GDP turns negative, 10-year yields tend to drop as well, such as during the recessions of 2008 and 2020 (circled areas).

This is not to say that all equity investors should be buying the longest tenured bonds possible. We believe these long maturity assets become increasingly attractive when an investor is taking on more risk within their equity portfolio. This creates a two-front decision matrix, where an investor must consider both the relative value of treasuries and the holistic risk profile of their portfolio when considering hedging risk.

Hedging Against Stagflation is a Little More Complicated… Prefer Energy Over TIPS for Risk-Tolerant Portfolios

Another potential downside risk a portfolio manager may seek to hedge is stagflation, or the combination of economic STAGnation and elevated inFLATION. As we discussed in a previous Strategic View, stagflation requires different forms of portfolio protection relative to a ‘garden-variety’ disinflationary recession. Specifically, Treasury Inflation-Protected Securities (‘TIPS’) are often considered a good hedge against inflation within fixed income. For managers who are strictly attempting to beat a fixed income benchmark, TIPS can provide a way to help insulate their portfolio against inflation. However, for a multi-asset portfolio, TIPS with longer maturities often perform poorly in times of rising inflation if interest rates are rising at the same time. In these circumstances, TIPS with shorter maturities can be much more effective, but are not the panacea they are often chalked up to be. For starters, since they tend to be a popular inflation hedge, they can often be overvalued when inflation risk looms. Secondly, given their low coupon rates, they have a large amount of interest rate sensitivity relative to similar maturity current coupon bonds. This becomes an acute issue because when expected inflation spikes, rates usually follow, causing potential losses in TIPS.

Since we are viewing this from the perspective of a multi-asset allocator, we would also point to both energy commodities and energy equities as a potential inflation hedge. Both of these instruments can be effective hedges against inflation but come with their own downsides. Direct investments in commodities come with poor tax treatments and a lack of cash flows, in our view, while we believe energy equities are only good hedges for early stages of stagflation. However, since we put a low probability on stagflation and view energy stocks as currently undervalued, they are our preferred stagflation hedge currently in more risk-seeking portfolios.

Corporate Bonds Can Offer Equity-Like Returns…In the Right Environment

When considering corporate bonds in the context of a traditional fixed income portfolio, yield is often the desired goal. For example, in the current market, the high yield market is yielding 7.43% and defaults are well below historical averages. We believe that these factors combined create an attractive yield opportunity relative to the broad fixed income market.

However, from a multi-asset perspective, we believe an investor must also consider the total return of these bonds, including price appreciation. For corporate bonds, this price appreciation often comes from movements in credit ‘spreads’ (the incremental yield an investor earns over treasuries for taking credit risk). Specifically, when ‘spreads’ contract corporate bond prices rally, and vice versa. This relationship is why context matters when making a credit investment in a multi-asset portfolio. When an investor’s starting point is tight spreads, there is little room for further tightening. Conversely, when investing in credit during a ‘wider’ spread environment, there is more potential for spread tightening and thus total returns that exceed current yields. Considering today’s market again, spreads are currently tight relative to history. Thus, we believe, within the context of a multi-asset portfolio, corporate bonds are less attractive than they are in the context of a fixed income portfolio. This is why we are overweight equities relative to fixed income across our balanced portfolios.

Conclusion: Portfolio Context is Key for Fixed Income

Within the context of multi-asset portfolios, we believe combining longer duration Treasuries with selective credit exposures is an efficient way to enhance total returns and provide protection against recession. However, these features must be considered in the context of the equity portion of the portfolios. For example, our long horizon portfolios are currently overweight equity relative to our global benchmarks, so we have a dedicated position in 25+ year, zero coupon treasuries. Since these bonds do not pay coupons, they are highly sensitive to interest rates, which makes them efficient because it takes less capital to adjust the desired maturity profile of the portfolio. As we either add to or trim our equity allocation, it would follow that we would adjust this hedge to arrive at our desired risk profile for the whole portfolio. A similar dynamic would exist if we began to add more credit risk to these portfolios; we would adjust (or at least reevaluate) the risk profile of our equity selection to make sure we are not unintentionally over risking our portfolio.

Risk Discussion: All investments in securities, including the strategies discussed above, include a risk of loss of principal (invested amount) and any profits that have not been realized. Markets fluctuate substantially over time, and have experienced increased volatility in recent years due to global and domestic economic events. Performance of any investment is not guaranteed. In a rising interest rate environment, the value of fixed-income securities generally declines. Diversification does not guarantee a profit or protect against a loss. Investments in international and emerging markets securities include exposure to risks such as currency fluctuations, foreign taxes and regulations, and the potential for illiquid markets and political instability. Please see the end of this publication for more disclosures.