Further aiding investors' comfort level in being overweight in fixed income has been the Federal Reserve, whose loose monetary policies and market interventions have worked to induce a kind of "Permanent Bond State" where the traditional risks of fixed-income investing have ceased to exist. The Fed may have the power to keep investors irrevocably allocated to bonds for the indefinite future with its commitment to low interest rates until at least late 2014, an ongoing Operation Twist, to keep long-term bond yields low, and the start of QE3. With the risk of rising bond yields eroding principal ostensibly off the table thanks to the Fed, bond investors' biggest problem these days seems to be finding bonds and stomaching the low yields.
Ironically, expectations about inflation have provided another boost to bonds even as yields have declined. Just as high inflation erodes the purchasing power of bonds' fixed payments over time, persistent low inflation makes future payouts all the more valuable. Remarkably, as a result of the disinflation inherent in the slow-growing U.S. economy today, the "real" yields on bonds-the amount they pay above inflation-is actually increasing, making buying and holding bonds an attractive proposition, at least as long as the U.S. economy is expected to be in the doldrums.
Admittedly, fear and the Fed may not be able to hold investors back from equities forever. Indeed, it may be subpar bond returns themselves that spark a reallocation from the asset class. After all, expecting bonds to perform as well in the future as they have over the past 30 years is unrealistic. With bond yields at record lows, the mathematics of total return simply won't allow it. Further, rising interest rates and inflation may not be as easily controlled as the Fed would have us believe.
After all, the Federal Reserve's swollen balance sheet and long-term commitment to low interest rates may be appropriate for the current low-growth environment, but should the economy advance to a more normal state or the rest of the world improve its condition enough to put the spotlight back on the U.S. and our unsustainable debt policies, the Fed's interventions would be difficult to roll back fast enough to avoid the spark of inflation. Some conspiracy theorists even argue that the Fed is comfortable with inflation running higher than bond yields, using financial repression as a back-door method of lowering our national debt.
For this reason, investors in bonds must be careful to consider the kind of fixed-income investments they are purchasing and be more focused on total return than yield in their portfolio management. The most interest-rate-sensitive segments of the bond markets, such as U.S. Treasurys, will be the most exposed to a backup in yields or a spike in inflation, and those securities offer little compensation for those risks these days. Corporate and municipal debt offer some incremental yield advantage, but are still highly correlated to movements in general market interest rates and vulnerable to the sting of inflation. Less correlated are sectors like high-yield debt, international and emerging-market bonds, convertible securities and preferred stock, though they introduce equity-like risks to a portfolio that may not be attractive to a traditional fixed-income investor.
Ultimately, the best argument for investors is to avoid over-allocating to any asset class and to prudently blend a mix of bonds and equity in fulfillment of the central tenets of modern portfolio theory. Rather than focusing on one asset class to the exclusion of another, given emotions or naïve expectations of future performance, investors must return to the fundamentals of asset allocation and develop an intermediate to long-term framework of risk tolerance and financial objectives that supersedes all else. As advisors, we must guide our clients in this process, and be disciplined both in our initial implementation and ongoing practice management. After all, a so-called "Great Reallocation" from bonds to stocks is one kind of financial market apocalypse we can all live without.
Michelle Knight is chief economist and managing director of fixed income at Silver Bridge (www.silverbridgegroup.com), an independent wealth advisory and multi-family office boutique. All investment advisory services are provided by Silver Bridge Capital Management LLC, a registered investment advisor affiliated with Silver Bridge.