With interest rates low but firmly on the rise, many investors are rethinking their fixed-income allocations. Some are adding risks to eke out additional yield, while others are taking measures to preserve and protect their assets as rates increase.
But professional bond managers are urging investors not to abandon their core fixed-income allocations in a search for income or protection.
For more than 30 years, the humble, low-risk 10-year Treasury bond has offered investors portfolio diversification, capital preservation and a steady stream of income. However, the zero- and negative interest rate policies ushered in by the global financial crisis broke that bond’s ability to provide much of an income stream, and tightening monetary conditions ever since have hampered its ability to provide capital preservation.
As the bond market shifts, investors may have to change their thinking about allocating to fixed income, says Michael Kushma, global CIO of fixed income at Morgan Stanley.
As the Federal Reserve pursued a policy of gradual interest rate increases through the summer of 2018, intermediate- and long-term Treasurys also rose gradually. Then as the Fed raised rates for the third time in 2018 at the end of September after a spate of positive economic news, U.S. Treasury yields leaped higher.
In September, DoubleLine Capital CEO Jeffrey Gundlach called it a “game-changer” when the 30-year Treasury twice closed above 3.25% in the first week of October. Gundlach has called for faster inflation and more aggressive interest rate increases as monetary tightening and fiscal stimulus alter the dynamics of the Treasury market, creating a difficult environment for traditional fixed-income investors.
But Mike Collins, a senior portfolio manager at PGIM Fixed Income, argues just the opposite. “Now might be the time to embrace longer duration bond funds,” says Collins. “The increase we’ve had in yields has been so sharp, and so pronounced, and returns have been negative, but you might want to go ahead and lock up some of these higher yields now.”
Collins and PGIM believe interest rates are at or near their peak along many parts of the yield curve, that growth will slow and that the impact of inflation and interest rates will remain low. Thus, rather than following the bulk of fixed-income investors who have shortened the durations of their portfolios in the face of rising rates, PGIM is advocating a return to the long bond.
For income-oriented investors, the case for long bonds makes sense. The yield on the one-year Treasury is now higher than the S&P 500’s dividend yield. For investors who use bonds primarily for income, the loss of capital caused by rising rates doesn’t matter—if they hold the bonds to term, they can continually reinvest their returned principal at higher yields.
Yet the rising interest rate policy is reducing the diversification benefit that Treasury bonds once provided to portfolios, says Henry Peabody, portfolio manager for the Eaton Vance Multisector Income Fund. “Today you’re getting higher rates as an offset to fiscal policy, which can cause or contribute to weakness in equity markets,” says Peabody. “The diversification benefits of bonds are being reduced, which makes an investment portfolio in general more risky.”
Another concern raised by bond investors is the shape of the yield curve—an inverted curve, in which short-term bond yields are greater than long-term bond yields, is considered a harbinger of recession, with negative growth typically occurring within six to 18 months after the curve upends.
Today, the yield curve is flattening. At the start of 2017, the spread between two-year and 10-year Treasury bonds was more than 0.5 percentage points. It had shrunk to as little as 0.2 percentage points in the early part of the third quarter of 2018. “I believe there is a linkage, higher rates driven by the Fed leads to a flatter curve, which leads to asset prices declining and an actual decline in economic activity,” says Peabody.
Looking at statements from central bankers, some investors believe the situation is unique because years of accommodative monetary policy kept long-term yields muted.
“I think the Fed is whistling past the graveyard to some extent by claiming that this time might be different and a flat curve will not be a harbinger of recession,” says Collins. “I think a flattening yield curve changes investor behavior. Investors will move into shorter securities. It’s a cause of recession, not a sign.”
Another concern nipping at the heels of fixed-income investors is inflation. Most U.S. inflation metrics have been stagnant throughout 2018, yet fiscal stimulus, economic growth, near-full employment, increased tariffs on global trade and rising commodity prices should all be causing an increase in inflation.
Priscilla Hancock, a fixed-income strategist at J.P. Morgan Asset Management, says that the measures used by central banks and the financial media may be missing some elements of inflation.
“There are other parts of inflation that may be silent or missing from public statistics,” says Hancock. “There are two sides of inflation, one is cyclical—we’re at the point where unemployment is very low and that should lead to wage growth. Tariffs should be inflationary by definition. The other half is structural: Are there long-term things that will prevent inflation from rising back to the level we’ve seen in the 1980s?”
Forces like globalization, technology, slowing demographic growth and high levels of competition have thus far kept inflation in check, says Kushma.
“By and large, inflation is a fairly irrelevant calculation from what you need to worry about,” says Kushma. “It’s an outlier, a tail risk for sure. I wouldn’t worry about it in terms of mainstream investing. Inflation has been well-anchored for 20 years.”
Yet the impact of fiscal stimulus growing the national debt and quantitative tightening should flood the Treasury market with new supply, putting additional upward pressure on interest rates.
So what are bond investors to do in light of the challenges they face in such an environment? Hancock argues they should seek out experienced active managers to avoid the glut of Treasury bonds inside passive indexes like the Bloomberg Barclays U.S. Aggregate Bond Index.
“It’s a good time for active management for that reason, and when you look at the composition of indices using the Agg as an example, half of the U.S. investment-grade corporate market isn’t in the Agg index,” says Hancock. “An active strategist looks for opportunities to deliver low volatility but perhaps have better metrics to offset the impact of rising rates.”
Multisector managers like Peabody seek idiosyncratic risk in fixed-income markets by focusing on security selection. Peabody finds opportunities in fallen angels and unloved countries in corporate and sovereign markets, receiving higher yields while minimizing additional risk.
Investors who need both yield and capital preservation and who are concerned about rising interest rates may also use a barbell strategy in their bond portfolio, says Rick Fulford, head of U.S. retirement business at PIMCO. In the most common barbell strategy, investors use two parts of the yield curve, one in intermediate or longer duration bonds to generate yield, another in shorter duration vehicles to dampen the impacts of interest rate increases and inflation.
Fulford also argues that investors can pair a traditional intermediate-term “core” fixed-income strategy with another, more active bond fund to create more internal diversification within their fixed-income allocations.
“Recognizing that bonds today have a lot of interest rate risk, there’s an opportunity to mitigate some of that risk and to offset it with safe yet higher yielding securities found by a manager with a broad, flexible mandate,” says Fulford. “Strategies such as unconstrained or multisector bond strategies have seen a lot of interest as a complement to core bonds that create more opportunity than just a core bond fund alone.”
Hancock says that investors could also access managers who add TIPS or pure inflation from swaps as a hedge within their portfolio in lieu of shortening duration. “The challenge is that by substituting ultra-short bonds for their core, investors are making a mistake,” says Hancock. “When you use ultra-short bonds, you give up most of the negative correlation to equities that you get from the core of your fixed-income allocation.”
While many investors are enticed by the yields and returns offered by dividend-paying equities and cash flow-producing alternatives, the managers cautioned against reducing allocations to bonds within a portfolio.
As yields continue to rise, bond investors who stay the course will eventually be rewarded for their patience, says Fulford. “Yields today are higher than they were a year ago, and the return expectations for bonds are improving,” says Fulford. “There’s no replacement for the income production and stability that bonds produce. For a retiree, that’s a primary consideration.”