A Key Rebalancing Consideration: Drawdowns

September 16, 2020 | , , ,

In times of market turbulence, investments may sustain peak-to-trough declines known as drawdowns. The COVID-induced drawdown in March was no exception. Our chart this week illustrates the drawdown history for core bonds, bank loans, high yield bonds, and hard currency sovereign emerging markets debt (“EMD”) compared with the S&P 500. While past performance is not indicative of future returns, historical drawdown risk associated with past market volatility is a helpful metric to consider in the recovery from the current global health pandemic. As evident in the chart, each of the fixed income plus sectors¹ is correlated with the S&P 500, but the magnitude of plus sector drawdown risk is much less than the magnitude of equity drawdown risk — with one notable exception. In the 1990s EMD exhibited larger drawdowns than equity. At that time, EMD was very thinly traded, less mature, and more susceptible to dramatic swings.

While rebalancing from equity to fixed income plus sectors increases credit risk and introduces some drawdown risk, the magnitude of that drawdown risk from plus sectors is expected to be less than the expected drawdown risk from equity. As such, in this low Treasury yield environment, we recommend that investors consider both fixed income plus sectors and equity as ways to achieve greater total return potential and yield in portfolios. A diversified portfolio that takes advantage of the lower correlations between bank loans, high yield, EMD, and equities may benefit from greater efficiency and a higher Sharpe ratio in addition to the lower-magnitude drawdown risk from plus sectors.

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¹Bank loans, high yield bonds, and emerging markets debt.