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Fixed income biases—how they may affect your portfolioVideo

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Transcript Browser Title: Markets Monthly February 2019 - Fixed Income Biases

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Transcript: <p>[techno music]</p> <p><b>Mr. Manoukian:&nbsp;</b>Hi, my name is Jake Manoukian. Welcome to the<br> February edition of Markets Monthly. This month, I'm lucky enough to be joined<br> by Irena Alagic, she's a Fixed Income Specialist on our team. Irena, thanks so<br> much for joining us.</p> <p><b>Ms. Alagic: </b>My pleasure.</p> <p><b>Mr. Manoukian:&nbsp;</b>So last time Irena was with us was over the<br> summer in 2018, and since then, we've seen a pretty substantial period of<br> market volatility, and when we think about that market volatility, what it<br> really means in layman's terms is that equities are going down, and when<br> equities go down, investors usually find themselves caught between this tug of<br> war between fundamental investing based on your goals and having a disciplined<br> approach, and then the kind of emotional side of investing. Those biases are<br> really important to examine as investors, and I just feel that a lot of the<br> time we frame those conversations in the context of equity investing, but I<br> have a feeling they exist in fixed income investing as well.</p> <p><b>Ms. Alagic:</b>&nbsp;Yeah. Look, we're humans first and investors<br> second, and what that means is that in a lot of instances, we don't make the<br> most optimal decisions. We are prone to biases, and those biases can be costly,<br> and I know we often talk about them in the context of equity investing, but<br> it's just as pervasive in fixed income, and so what we really want to make sure<br> we do is isolate some of the most common biases we come across within fixed<br> income investing, so that we can give fixed income the opportunity to do what<br> we essentially hired it to do in a portfolio, whether it be income generation,<br> capital preservation, diversification, you name it.</p> <p><b>Mr. Manoukian:&nbsp;</b>Yeah, so I love this idea of, of thinking<br> about what you hire fixed income to do in your portfolio. One of the most<br> important things that many investors hire fixed income to do is provide a<br> cushion against the volatility that equities have.</p> <p><b>Ms. Alagic:</b>&nbsp;Right.</p> <p><b>Mr. Manoukian:</b>&nbsp;Now, there's this kind of theory that's<br> starting to bubble up in the market narrative that because interest rates are<br> so low, fixed income won't have the same amount of that diversification<br> protection that it has provided historically against equity risk in the past.<br> What is your take on this theory?</p> <p><b>Ms. Alagic:</b>&nbsp;Look, I think the main thing you need to do<br> really is just to look at 2018 as a reasonable case study, right, especially<br> the fourth quarter, and especially December, right? In December, the S&amp;P<br> was down about nine percent, and the Barclays AG Broad Fixed Income Index that<br> we use was up two, so I think especially as we get later in the economic cycle,<br> it's important to own the appropriate amount of core fixed income so that you<br> can get that benefit if we have more volatility, which by the way, we think<br> we're definitely going to have.</p> <p><b>Mr. Manoukian:&nbsp;</b>So the fourth quarter of 2018 suggested to us<br> that fixed income could still provide that diversification benefit against<br> equities.</p> <p><b>Ms. Alagic:</b>&nbsp;Oh, for sure, for sure.</p> <p><b>Mr. Manoukian:&nbsp;</b>So another kind of recency bias that<br> definitely shows up in equity markets is performance chasing- the desire to buy<br> assets that have appreciated a lot, and the desire to sell assets that have<br> depreciated a lot. What is that like, and how does that manifest itself in<br> fixed income?</p> <p><b>Ms. Alagic:&nbsp;</b>Yeah, recency bias really refers to this idea<br> that you take what has happened recently, and you extrapolate it into the<br> future, and we absolutely see that behavior in fixed income investing as well,<br> whether it's chasing positive performance, or selling on the back of a couple<br> of months of negative returns, and look, it's not that we're saying don't sell<br> ever. You have to take a step back and consider whether your original<br> investment thesis has changed, but what we end up experiencing in reality in<br> most cases is that people don't actually have the discipline to go back and<br> think through why they own this in the first place, and whether something<br> fundamentally has changed about the thesis, so we have this experience where<br> people tend to sell first and ask questions later.</p> <p><b>Mr. Manoukian:&nbsp;</b>Yeah. Again, it goes back to that concept of<br> what might be more important than the short-term price fluctuations-</p> <p><b>Ms. Alagic:</b>&nbsp;Right.</p> <p><b>Mr. Manoukian:&nbsp;</b>-is really thinking about what the reason<br> that you have the asset in the portfolio is.</p> <p><b>Ms. Alagic:&nbsp;</b>Right.</p> <p><b>Mr. Manoukian:</b>&nbsp;So going back to this idea of why hire fixed<br> income at all- one of the main reasons is for actual income generation, so how<br> do you think about income generation as a fixed income investor?</p> <p><b>Ms. Alagic:&nbsp;</b>Well, it's related to what we just spoke<br> about, this concept of recency bias, and, you know, selling first and asking<br> questions later, and we absolutely do see people forgetting that the income<br> portion of fixed income is supposed to work for them, right? So for most fixed<br> income instruments, your return is comprised of price return and your coupon,<br> and if you react and you sell a bond without thinking about, have the<br> circumstances materially changed, or is this just a temporary price<br> dislocation, you end up crystallizing the loss, and then you haven't given<br> yourself the opportunity to earn out the coupon, and the coupon is ultimately<br> what's going to help cushion your total return experience over your holding<br> period for that security. And again, if circumstances have changed, then it's<br> absolutely worth reevaluating, right? But in a lot of cases, again, it's very<br> reactionary behavior. You just react to what has happened recently, as opposed<br> to look ahead.</p> <p><b>Mr. Manoukian:</b>&nbsp;I might be oversimplifying, but one of the<br> refreshing things about fixed income investing to me is that as long as that<br> you believe that the issuer, or the entity that you're lending money to, will<br> pay you back, you have a pretty good idea of what your return experience will<br> be like.</p> <p><b>Ms. Alagic:&nbsp;</b>Right, right.</p> <p><b>Mr. Manoukian:&nbsp;</b>Now, the one that we want to end on is this<br> idea of reach for yield behavior, that is really, in large part, caused by this<br> air of quantitative easing, where central banks took a really active and large<br> position in asset markets and fixed income markets. How are you seeing that<br> play out, now that the era of quantitative easing is coming to an end?</p> <p><b>Ms. Alagic:</b>&nbsp;Yeah. Look, we see a lot of that behavior<br> still happening, and I think it's just now starting to get unwound. As we sort<br> of switch from quantitative easing to quantitative tightening, we had a hundred<br> basis points of Fed hikes in 2018, the balance sheet has been reduced, and it's<br> going to continue, and what's happened as a result of that is that a lot of<br> people, a lot of investors have gone down, for example, in credit quality,<br> without getting the proper compensation for it, or taken on more liquid<br> investments, again, without getting adequately compensated for it, so at some<br> point, we are going to have a downturn in credit, and at that point, it's<br> really going to pay to know what you own. You can't really just rely on ratings,<br> and there are parts of the fixed income market that are not going to provide<br> you the same protection as they have in the past, so you really want to take a<br> very close look at where have underwriting standards deteriorated.</p> <p><b>Mr. Manoukian:</b>&nbsp;So it's really important to ask the question<br> about am I getting compensated for the amount of risk I'm taking?</p> <p><b>Ms. Alagic:&nbsp;</b>For sure.</p> <p><b>Mr. Manoukian:&nbsp;</b>So we've covered a lot over those four<br> biases, but I think in times of market volatility, it's more important than<br> ever to really reflect on those biases with the help of your advisor, and<br> really to make sure that fixed income is doing the job that we hire it to do in<br> your portfolios. So Irena, thank you so much for spending the time.</p> <p><b>Ms. Alagic:</b>&nbsp;My pleasure.</p> <p><b>Mr. Manoukian:</b>&nbsp;Hopefully, we'll have you back in a couple of<br> months.</p> <p><b>Ms. Alagic:&nbsp;</b>I hope so.</p> <p><b>Mr. Manoukian:</b>&nbsp;And hopefully, we'll see you next month for<br> the March edition of Markets Monthly. Thank you.</p>

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