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.