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Why finding "safety" in bonds may be challenging

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The views expressed in these posts are those of the authors and are current only through the date stated. These views are subject to change at any time based upon market or other conditions, and Eaton Vance disclaims any responsibility to update such views. These views may not be relied upon as investment advice and, because investment decisions for Eaton Vance are based on many factors, may not be relied upon as an indication of trading intent on behalf of any Eaton Vance fund. The discussion herein is general in nature and is provided for informational purposes only. There is no guarantee as to its accuracy or completeness. Past performance is no guarantee of future results.

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      By Kathleen C. Gaffney, CFA, Director of Diversified Fixed Income, Eaton Vance Management and Henry Peabody, CFA, Diversified Fixed Income Portfolio Manager, Eaton Vance Management

      Boston - Now that a scary October is in the books, investors will be looking for reasons to explain the sell-off in equities and other "riskier" assets. And the list has plenty of culprits, including tariffs and trade-war fears, next week's midterm elections and rising interest rates.

      However, during choppier markets we try always to separate the "signal" from the "noise."

      For example, one common refrain this week is that rising rates and bond-market volatility have spilled over into stocks. That may be true, but to us, it's just noise.

      Instead, the true signal to us is that many "safe" bond sectors fell in October along with equities. If this is an emerging trend, it has important implications for portfolio construction and risk management. It also ties in to the "new playbook" for bond investing we've covered in our recent blog posts.

      Is "safe" really safe?

      The Bloomberg Barclays US Aggregate Bond Index, or "Agg," lost 0.8% in October, while the S&P 500 Index fell 6.8% last month, according to Morningstar data.

      The Agg is a well-known benchmark for bond portfolios. However, it is comprised mainly of rate-sensitive, higher-quality U.S. bonds such as investment-grade corporate debt, Treasurys and mortgage-backed securities.

      In many traditional portfolios (such as 60/40 stock/bond allocations), the bond portion simply replicates the Agg or something similar. And that has worked fine during the multi-decade trend of falling yields and rising bond prices.

      The Agg has provided nice ballast over the last 20 years, as central-bank monetary policy has pushed yields lower and boosted risk appetites. Taking duration risk was a great way to benefit from the decline in interest rates.

      Yet, we have made the case in recent posts that we may be entering a new environment for fixed-income investing in which traditionally "safe" areas, such as long-duration U.S. Treasury bonds, may be anything but safe. We believe duration is no longer a tailwind, but rather a headwind. Treasury yields and interest rates may head higher due to several factors, including rising inflation, the hand-off of monetary to fiscal policy, and fewer buyers of U.S. assets.

      Regarding Treasurys, history shows that 10-year Treasury bonds and U.S. large-cap stocks can have positive correlations for extended periods, which reduces the diversification value of U.S. government debt.

      Blog Image Stock Treas Yield Corr Nov 2

      Source: Morningstar, as of 9/30/2018. Large-cap stocks measured by the IA SBBI US Large Stock Total Return USD Index. 10-year Treasury measured by the FTSE Treasury Benchmark 10 Year.Past performance is not a reliable indicator of future results.

      In other words, duration risk is a real threat with Treasury yields at such historically low levels, at a time when the Federal Reserve is hiking short-term rates and reducing the size of its balance sheet. Additionally, the U.S. government estimates it will issue over $1.3 trillion of Treasury debt in 2018 as the federal deficit grows.

      Rates are still very low historically, which provides little cushion as bond prices decline to reflect higher rates. Volatility in prices could then potentially inflict more pain and may push the Agg further into negative territory for 2018.

      Flexibility is key

      Again, our view is that duration risk is very important right now, and that traditional bond safe havens such as Treasurys might not provide enough protection. That's why we think flexibility and going beyond the Agg are key in a fixed-income market that may be in a significant transition. This is also why this may be a time to think about fixed income a bit differently.

      We think taking advantage of behavioral characteristics inherent in fixed-income markets may provide an ongoing source of return. Specifically, thinking about the preferences of certain investors may be a way to find further opportunity. For example, the temporary nature of some inexperienced "crossover" buyers in emerging market (EM) debt can create value when signs of volatility frighten this group. Additionally, the asymmetry of fixed-income returns can result in a discrepancy in current price versus long-term intrinsic value that may be realized over time by those willing to listen to the volatility.

      Bottom line: We think moving beyond the Agg and traditional bond strategies makes sense now. We think of a barbell strategy as spanning duration, country and volatility characteristics by holding cash and select emerging market positions that reflect idiosyncratic risk, rather than broad-market risk. This may allow us to participate in positive fundamentals, at a discount to fair value, while waiting for value to emerge in U.S. credit and markets.