Is there a FOMO, or fear of missing out, mindset developing in the U.S. bond market? Incredulous investors might hear that and sarcastically ask, “Fear of missing out on what? Losing more money on falling bond prices while collecting insufficient yield during a period of rampant inflation?”
Fixed income is generally seen as safe and boring, yet on the whole this asset class has been anything but in 2022. According to Sara Devereux, principal and global head of fixed income at Vanguard, the first quarter marked the bond market’s worst performance in more than 40 years. She said that has prompted some of her firm’s clients to question the role of bonds in 60/40 portfolios, or whether they should shorten duration and seek risk premium from credit or private assets.
Speaking to an audience of financial advisors and others during a presentation this week at the Exchange ETF conference in Miami Beach, Fla., she speculated that advisors are hearing those questions from their clients, too. But she cautioned advisors against throwing in the towel and giving up on traditional bonds. Despite the seeming gloom, she said, there are glimmers of optimism.
“More recently, I’ve heard from others who want to take the other side because yields have moved a lot and valuations look attractive,” Devereux said. “There are little signs of FOMO creeping into the bond market.”
She noted the top three concerns among fixed-income investors are inflation, the impact of the Federal Reserve’s plan to consistently raise interest rates in order to tame inflation, and low return expectations.
Inflation zoomed to a four-decade high of 8.5% in March. “We think inflation and central bank response to it will remain a key risk in the markets both this year and next," Devereux said.
She noted the markets have already priced in 11 Fed rate hikes, but the good news is that higher rates imply higher future returns.
“Our return outlook for the next decade will be upward of a range of 2% to 3% per year,” Devereux stated. “Parts of the bond market are starting to look attractive again for the first time in a while.”
Nonetheless, she noted, the bond market faces a lot of unknowns. In an attempt to mitigate that uncertainty, she highlighted four core general strategies for long-term success no matter what the environment. They are as follows:
Stay Diversified
Devereux stressed that clients should own bonds as a diversifier to equity risk, even with rates moving higher. “Diversification is the only free lunch in investing,” she offered.
She presented a chart showing median returns of various asset classes during the worst decile of monthly U.S. equity performance over the 20-year period ended February 28, 2022. The upshot was that six of the eight bond categories presented (the exceptions being emerging market government bonds and U.S. high-yield bonds) were in the green while all five equity categories, plus commodities, were in the red.
“Our model shows that when stocks fall, fixed income will hold its own,” Devereux said. “While there may be short-term periods of volatility and dislocation, over the long term bonds are an effective diversifier. You can’t expect that relationship to hold each and every day, but rather on average over your investment horizon.”
She recommends that advisors remain disciplined and focused on the long term even during periods of short-term upheaval.
“Don’t let changes in interest rates drive strategic shifts in your clients’ fixed-income allocation,” she said, adding that a client’s fixed-income exposure should depend on the size of their equity exposure and their individual risk tolerance.
Maintain A Proper Risk Profile
Devereux emphasized the importance of keeping risk in proper perspective within a fixed-income allocation.
For example, she said, many advisors have shortened the duration of their fixed-income exposure to reduce interest rate sensitivity. (Duration is a measure of a debt instrument’s sensitivity to changes in interest rates.) Lower-duration fixed-income securities typically have lower yields, so advisors try to fill in the yield gap by adding credit risk such as high yield or emerging markets.
This is strategy might look great on paper because riskier assets are expected to produce higher returns on average, she said, but this could produce a more equity-like fixed-income portfolio that may not respond as expected in an equity market correction.
"When equities tumble, higher yielding bonds, such as high yield and emerging markets, tend to have a similar risk-off action to equities, failing to provide the cushion that investment-grade bonds offer,” she said.
Devereux added that she’s not against trying to diversity bond exposure in an effort to generate more income for clients, but she suggests funding that from a portfolio’s equity allocation to remain in line with a client’s risk tolerance profile.
Harness Duration
Devereux said she often sees advisors shifting duration because clients expect it or even demand it. “Typically, we’ll see advisors stack portfolios at the short end of the yield curve because it might feel safe,” she noted, adding that such a move might have a negative impact on returns because it is mathematically proven that trading duration isn’t a reliable source of return.
“We suggest that rather than trying to time the duration market, you harness duration by constructing portfolios tailored to the appropriate time horizon,” she said.
She explained that rising rates can actually be good for bond investors if their investing horizon is longer than the portfolio’s duration.
“If that’s the case, the higher yields on reinvested cash flow can outweigh market price declines,” she said. “There may be some short-term pain, but your clients should be rewarded long term because coupons help cushion the blow no matter what the duration, and if you’re reinvesting the coupon payments for clients the rising rates over time will help deliver better results.”
Take Control
“Whatever strategy you use for clients, there are three things that are a must: low cost, risk management and skill,” Devereux told advisors in the audience. “How you implement the fixed-income allocation in your clients’ portfolios depends on how much and what type of control you want to have” whether that’s picking the investments yourself or hiring an outside manager to do it.
Advisors can get general exposure to the entire bond market via one or a few funds such as an index-based total bond-type ETF or a core, actively managed bond fund. And they can supplement that with a building-block approach enabling them to be active in sector rotation by overweighting or underweighting certain parts of the bond universe.
“You can also target duration in a precise manner, which can be done to help clients meet their needs within a specific time horizon," Devereux noted.
She added that some parts of the bond market, such as high yield or emerging markets, lend themselves to active management. Regarding active funds, Devereux stressed it’s important to work with an experienced manager with strict risk controls, and to be mindful of fees because it affects risk taking.
“High-cost active managers must take more risk just to reach their fee threshold before they can return a single basis point of return to their clients,” she said.