Outlook 2021: Fixed Income
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Greetings. I’m Brett Wander, Chief Investment Officer, Fixed Income. I’d like to describe three key themes that will affect fixed income investing over the next 12 to 18 months, continually low yields, the importance of inflation protection, and divergence within the municipal bond market.
Interest rates are very likely to stay low for quite a long time. First, we have slow economic growth across the globe caused by COVID. In response to the decline in economic growth, central banks across the world are working to lower interest rates in order to stimulate their economies. Over the long-term when stocks plunge, as they did in March and April of 2020, bond yields fall, and the price return on bonds will act as a cushion.
Now, a lot of people feel that’s not happening anymore, but my personal viewpoint is that if we did see a significant decline in equities then bonds would, in fact, be an effective hedge, as they always have been.
It’s important to remember that bonds are generally effective as a hedge to equity, whether interest rates are high or low. If you felt comfortable with your strategic allocation to fixed income a couple of years ago when yields were a little higher, that’s probably a reasonable place to be going forward.
Now, in addition to the low government bond yields, credit spreads are tight, which means that investors are not getting paid much to go down in credit quality. So I would suggest staying focused on diversified, highly liquid investment-grade fixed income, and not reaching for yield with strategies that have more risk and higher correlations with equity markets.
The second theme for 2021 and beyond involves the importance of inflation protection. If you can protect yourself from inflation at a very low cost, that’s likely to be a very wise investment decision. We don’t know if inflation will rise significantly or not, but there are certainly reasons it could. Massive government spending, the Fed’s $5 trillion balance sheet, and more stimulus packages likely on the way.
It’s likely the best way to protect yourself from inflation, is to hold treasury inflation-protected securities, or TIPS. The way TIPS are currently trading, an investor gives up very little income in order to attain this protection. If inflation fails to materialize, the lost opportunity is minimal. However, if inflation were to increase, investors would have securities specifically engineered to benefit in this scenario. ETF and mutual funds are ideal vehicles for TIPS in my view, because they’re diversified and liquid.
Municipal bonds need to be approached a little bit differently than they used to be. Many investors have traditionally thought of municipal bonds as a tax-free version of a treasury security.
You didn’t have to think much about credit problems, but to think of munis as a risk-free asset is a mistake when the economy is struggling. When housing prices are falling in certain areas, when many businesses are suffering, and tax receipts are going to be a lot lower than expected to treat all municipal bonds the same could also be very risky.
And that’s why, now more than ever, I believe the wisest approach to the municipal bond market is to have a thoughtful, intelligent credit process, to be disciplined, and not be tempted to chase the highest yields. You want to have professionals who are evaluating the strengths of the bond’s credit quality, security-by-security, and building diversified portfolios. That’s why I recommend municipal bond investors use mutual funds managed by discriminating managers with strong credit research capabilities.
In closing, I’d like to remind investors about the perils of reaching for yield. Focus instead on maintaining liquidity and diversification, and look for inexpensive ways to acquire inflation protection. Most important, be mindful that fixed income’s ability to protect against equity market downturns is just as meaningful when interest rates are low as it is when they’re high.