Navigating fixed income in 2021 and beyond
Bonds can be an effective hedge to equities despite the very low interest rates.
The inflation outlook is unclear, but Treasury Inflation-Protected Securities (TIPS) offer potential protection against inflation.
In the municipal bond market, rigorous credit analysis is more important than ever.
For fixed income to help balance out other holdings, keep it liquid, high quality, and diversified.
Investors have never faced a fixed-income market like the current one. Interest rates are at rock-bottom levels everywhere. It’s nearly impossible to predict the direction of inflation. And the COVID-19 pandemic has reshuffled the economy.
Looking ahead, we think fixed-income investors can better navigate this environment if they focus on these three themes:
- Continually low yields
- The importance of inflation protection
- Divergence in the municipal bond market
What low rates don’t mean for your bond portfolio
Low interest rates are one of the defining characteristics of today’s financial markets. And rates are likely to stay low for quite some time: The U.S. Federal Reserve and other central banks around the globe have signaled that they intend to keep interest rates low for the foreseeable future to stimulate fragile economies.
Some investors worry that low yields reduce bonds’ ability to hedge equity market downturns. We think that concern may be misguided.
Historically, bond yields have tended to fall during major stock market declines, pushing up bond prices. With yields already low, can they drop much farther? Research suggests they can. And in 2020, the historical relationship between stocks and bonds held up when equity markets plummeted, with the yield on the 10-year Treasury falling to an all-time intraday low of 0.318% in March.
Possibly the most important single insight to remember is that bonds can be just as effective as a hedge to equities whether rates are high or low.
This realization can have important implications for bond investors. Low rates alone should not cause investors to change their strategic allocations. If they were comfortable with the size of their fixed-income allocation when rates were higher, the same allocation likely remains reasonable now.
Investors may be understandably concerned about their ability to generate income from their fixed-income portfolios. Yet they shouldn’t chase yield for yield’s sake. Credit spreads—the additional yield investors can gain by assuming more credit risk—are near all-time lows. In other words, lower-quality bonds don’t currently pay much to compensate for the greater credit risk they represent.
Further, lower-quality bonds tend to have higher correlations to equities. As a result, chasing higher yields could undermine the fixed-income allocation’s ability to hedge equity exposure—quite often the primary purpose for this piece of a portfolio.
Meanwhile, the yield curve is almost flat as of the end of 2020, with the 30-year U.S. Treasury bond yielding only about one percentage point more than the 7-year Treasury note. Again, investors are currently being paid little for taking on additional risk.
So, whether you invest in individual bonds, ETFs, mutual funds, or managed accounts, consider focusing not on pursuing higher yield, but instead on investing in highly liquid, investment-grade securities that are diversified by issuer, sector, and duration.
The case for inflation protection now
Will inflation rise? No one knows for certain. What we can say with certainty is that the range of potential inflation outcomes is much wider than normal.
On the one hand the global economy faces a range of deflationary forces, including economic weakness, aging demographics in developed economies and technological advances. On the other hand, there are highly inflationary forces. In particular, the massive liquidity that governments and central banks have injected into the financial system through interest rate cuts, quantitative easing and stimulus spending (with more stimulus likely on the way). If demand were to pick up—for example, if a widely distributed vaccine were to spur a quick snap-back in economic activity—the tremendous amount of money in the economy could contribute to rapidly rising prices.
The inflation outlook is highly uncertain. In situations with great uncertainty, it’s generally wise to seek protection—especially if that protection is available inexpensively.
That’s where TIPS can potentially play an important role. Inflation erodes purchasing power, reducing the relative value of each and every dollar of income. TIPS tend to outperform when inflation rises, thereby providing a hedge against the impact of rising inflation.
As of late 2020, yields on TIPS were only about one-and-a-half points lower than the yields on nominal U.S. Treasury securities, so investors had to give up very little yield for the inflation-fighting benefits that TIPS offer. In other words, safeguarding against potential inflation was relatively inexpensive.
An investor could also invest in TIPS through ETFs or mutual funds in order to gain a more diversified, liquid exposure to this valuable asset class.
Not your parents’ muni bond market
In the past, many investors approached the municipal bond market as if it was a tax-free substitute for U.S. Treasuries. They may have felt that they could ignore credit risk, and much of the time they were right. After all, the vast majority of municipal bonds historically have been quite stable and safe.
The municipal market calls for a new approach in 2021 and beyond. Economic lockdowns have undermined many municipalities’ tax receipts as well as their revenues from toll highways to airports. These changes may mean that investors can no longer take municipal bond credit quality for granted. The spectrum of risks has rarely been wider: some municipal bonds now carry considerable credit risk, while others have held up relatively well. Investors who treat all municipal bonds the same might take on much more risk than they expect.
Now more than ever, it’s wise to view the municipal bond market with a thoughtful, thorough credit research lens. As a result, we believe that investors would be well served to seek out funds managed by professionals who evaluate the creditworthiness of specific bonds security by security, make well-informed, disciplined judgements about the tradeoffs between yield and risk, and build diversified portfolios.
Don’t let the income tail wag the diversification dog
One of a bond allocation’s most important jobs is to help balance the risk in an overall portfolio context. This role may be more important now than it has ever been. To succeed, a fixed-income portfolio needs to provide both stability and a low or negative correlation to the equity market. Lower-quality, higher-yielding securities provide less of these essential benefits.
Low interest rates don’t change the potential for liquid, highly rated bonds to hedge against equity risks. Focusing bond allocations on a diversified mix of issuers in high-quality sectors, including U.S. Treasuries, TIPS, investment-grade corporate bonds, and municipal bonds, can help ensure that a fixed-income allocation continues to provide ballast for the overall portfolio.
- Liquid, high-quality bond funds, diversified by issuer, sector, and duration, may help your fixed-income allocation serve one of its most important purposes: protection.
- ETFs and mutual funds can provide diversified exposure to TIPS, helping prepare for potential inflation. Click here to learn more.
- Consider learning more about municipal bond funds run by managers who perform deep, security-by-security credit analysis.