During a trying time for the world in 1939, Winston Churchill famously described the largest country in the world and soon-to-be second superpower, the Soviet Union, as “a riddle wrapped in a mystery inside an enigma.” Today, investors may feel similarly perplexed with regard to the valuations of the largest financial asset in the world, the U.S. Treasury market, as we continue to ride out a different challenging chapter in world history. On the one hand, factors like the spread of the Covid delta variant, and fresh mobility restrictions, have resulted in a strong bid for risk free assets. But on the other hand, economic activity continues to exceed most expectations, reaching post-World War 2 highs, as vaccination rates creep higher across most of the world amid a release of pent up consumer demand.
The Profound Challenge of Investing in Fixed Income Today
Against this backdrop, the Bloomberg-Barclays Treasury Index offers investors almost exactly the odds of a coin flip in terms of whether they are likely to post a gain or a loss in total return for the rest of 2021, an unusually risky return profile for a risk free asset (based on its historical volatility). The U.S. Aggregate Index (Agg) offers little better prospects: at a 40% probability of loss over the next year, and the chances of losing money on an investment in the Agg are higher than at any time in its pre-pandemic history. Once inflation is taken into account, the likelihood of the Treasury Index ,or Agg, posting a negative real return rises further still. That would be the case even if inflation were to moderate to a more normal 2% to 3% range, instead of the recent 5+% readings. Given the sizeable skew in the distribution of outcomes toward negative real returns, it has become extremely important to be selective in high quality fixed income, and to be truly vested in one’s investments so that portfolios are not permanently impaired.
The world of spread assets displays a similar pattern. While one might argue that current spread levels are not unknown territory for corporate credit, the only other time in history that investment-grade and high yield index spreads were this tight was right before the Global Financial Crisis (GFC). And while spreads were able to maintain tight levels for many months back then, the probability of loss on corporate bonds was much lower, at less than 10% probability, because the coupons and all-in yields were double (or more) what they are today (see Figure 1).
Figure 1: The Probability of Loss in Credit Sectors is Much Higher Today Than Recent History
Sources: Bloomberg and BlackRock, data as of August 8, 2021