On this episode of The Long View, Eric Jacobson, Morningstar’s senior principal for fixed-income strategies, talks about what has changed the entire face of the bond market, passive fixed income, private debt, and why 2022 took so many investors off guard.
Here are a few highlights from Jacobson’s conversation with Dan Lefkovitz.
Why Investors Should Reconsider Trying to Be Tactical With Bonds
Dan Lefkovitz: Our colleague Christine Benz, the anchor host of this podcast, wrote an article recently about how investors seem to be taking a really tactical approach to fixed-income investing, swapping in and out of cash, taking bets on interest rates. Yet the investor return data show that they haven’t done a great job of timing their purchases and sales. Why do you think that is?
Eric Jacobson: It’s just really, really hard to get the timing right under any circumstances. Back in the ‘80s and early ’90s—especially because you had interest rates get to really long extremes during the mid-’80s, for example, late ‘70s or late ‘80s—there was a sense that you could do this. You could bet against interest rates, and so on. There are all kinds of reasons it became a lot clearer in the mid-’90s. For example, a lot of institutional investors said, “You know what, this is not a great thing to do because if you’re wrong and you bet against interest rates too strongly, the payoff isn’t good enough on the upside and it can be really bad on the downside.” It’s very hard to do it well consistently.
There have been a few managers over the decades who have done reasonably well with it. Very, very, very few. One of them was Bill Gross at Pimco. He hasn’t been managing money publicly for about 10 years. But even he made mistakes sometimes. The thing that a lot of people didn’t realize is he did it in a pretty measured way, and it wasn’t the only lever that he was pulling in terms of how to manage bond money, even though he had a big reputation for making good interest rate bets.
When It Comes to Bonds, Don’t Be a Hero
Rather than taking a tactical approach, tailor your fixed-income position to what matters: your spending goals.
Beyond that, it’s not something that you can really do well consistently over and over again over long periods of time, certainly when those bets are bigger. I’m not going to say it’s like predicting the weather. There’s a little bit more to it than that. But there are lots of reasons that interest rates move back and forth, and it’s not always that easy to sense what those are going to be. And I jumped right into that explanation. I know you were talking about going in bonds and cash, but what a lot of people are focused on is, are interest rates too low, or are they going to go up? It’s also very common—we don’t hear much about it lately—but it’s common for people to try and time in the high-yield bond market and jump in one month, jump out the other month, and so on. But as you alluded, it’s very hard to do that consistently, because ultimately, what you’re dealing with are market dynamics and trading dynamics that may not necessarily be anchored in anything super fundamental at any given moment. They may have a lot to do with market temperament and swings and expectations. Doing that is more of speculation than it is investing, in some ways.
Why the 2022 Bond Market Meltdown Took Investors Off Guard
Lefkovitz: Well, 2022 seems to be an example. It looks obvious in retrospect. The yields rose dramatically. The Fed and other central banks were responding to inflation by jacking up interest rates. But it seems to have caught a lot of people off guard.
Jacobson: It’s a difficult period to look back on because what sometimes happens in bond markets is you can get to what we think of as extremes. For example, when interest rates get very low, and start thinking, well, it’s obvious they’re going to go up, and it’s going to create problems, or it’s going to be a crash, and so on. The problem with bond markets, especially when you are talking about those that are anchored toward government bonds, is that sometimes those trends are structural in a sense. They happen for a reason that doesn’t change for a very long time.
So, for example, after the financial crisis, almost immediately, in fact, or during the financial crisis, people were already talking about how indebted the government was going to get and how low interest rates were going to be and how it was going to turn into a bubble. And we had to really be worried about interest rates rising very shortly after the financial crisis. In fact, it generated so much angst and so forth, there were whole new kinds of funds that were created to try and take advantage of that by saying, well, we’re going to keep interest rates low. We’re going to do everything else, but we’re going to protect you from rising interest rates because inevitably they’re going to spike up. That inevitability lasted for years and years. There were reasons that interest rates stayed low for a very long time after that. And knowing exactly when they’re going to spike up is very difficult.
And so, if you had positioned your portfolio, as an example, after the financial crisis, expecting that interest rates are going to spike at any time—in other words, we’re going to have a bear market like we had in 2022—you would have sat on the sidelines for years. And it would have cost you in terms of the opportunity cost. But also in a bond world, you can actually pay in a sense if you’re buying bonds and then hedging out the interest rate risk, that’s costing you.
That can happen with credit markets, too. Credit markets, when they do have sort of a bubble situation like we’re talking about, those are a little more likely to pop because they’re a little more drawn by market forces rather than big, big economic forces and central bank decisions. But even then, bubbles can last a whole lot longer than people realize. And there’s always a risk of staying out too long. I think the problem with 2022 is that you had a couple of things all happen at one time. Covid really changed the dynamics of everything because of all the central bank intervention and so forth.
So yes, can we look back and say, well, it should have been obvious that this was going to happen. But the problem is you’d have to know an awful lot about inflation. You would have had to been right. And you would have to know how soon it was going to happen. So, after the financial crisis, were you right in thinking that eventually interest rates were going to have to go up? Yes. But it took, I don’t know, more than a decade, a decade and a half? That’s really hard work.
Is Going Passive in Fixed Income a Mistake for Investors?
Lefkovitz: Let me ask you this, Eric: Do you think that going passive in fixed income is a mistake for investors?
Jacobson: I don’t. I think if you are looking for some sort of core exposure to especially very high-quality, highly liquid parts of the bond market, and you’re not going to pay very much at all because hopefully most index funds are going to be pretty cheap, you can get a pretty good exposure that way and not really give much up. For the most part, though, you’re going to be talking about Treasuries and high-quality corporate bonds and maybe the broad mortgage bond market. But there are a lot of things that are going to be left out if you just buy your plain-vanilla core market exposure, that you’re not going to get exposure to in the bond market. A lot of people may have heard of CLOs; they’re collateralized loan obligations. I’d have to go down a long list on the mortgage side of things that have become more and more popular with active managers but just don’t really exist in the big indexes. And even in sort of nichey things, it’s very hard to get index exposure to them.
I mentioned those. There are nonagency mortgages. They are not anything like they were 15 years ago after the financial crisis. There are different kinds now that are, I’m not going to say they’re automatically safer because there are all kinds of risks that can develop, but they give lots and lots of choices and opportunities to active managers that you’re just not going to get in a core index.
So, again, I’m definitely not against fixed-income indexing at all, but you certainly want it to be cheap, and you want to recognize that you’re not going to have the breadth of market that you might get by being more active. And you also want to recognize that because of the way the bond market has evolved since the financial crisis in the last several years, you may be taking on more interest rate risk than you thought you were, because, say, five, 10 years ago, the bond market was probably a little bit less rate-sensitive than it is today. You just want to make sure you understand that, or if you’re working with a financial planner, that they’re taking that into account.
