Bond Investors’ Dichotomy
George Bory, CFA, Fixed Income Strategy/Portfolio Strategist
The current dichotomy in fixed income is the upsurge in inflation over the past year, while bond yields have remained stubbornly low. As a result, much of the world’s bond market—at least in the developed world—currently offers deeply negative real yields when compared with current inflation rates and modestly negative yields when compared with medium-term inflation expectations.
To be fair, since the start of the year, bond investors seem to be more intensely involved and have started to reprice the entire term structure of the yield curve to reflect the very real possibility that monetary policy will need to get much tighter more quickly if central banks want to or need to get inflation under control. Indeed, the bond market is now pricing in three to four rate hikes in the U.S. in 2022 and a high probability that the Federal Reserve (Fed) will wind down its current quantitative easing program very quickly and may even start quantitative tightening in the second half of the year.
The best-case scenario for central banks and the market is that inflation organically decelerates in an orderly fashion, which would temper the need for central banks to react aggressively. But inflation is only one side of the coin—the other is the labor market. Recent reports show the U.S. economy is quickly reaching “full” employment. With U.S. headline inflation currently running around 7% and unemployment under 4%, a federal funds target rate at 0.125% and a 10-year U.S. Treasury yield at 1.75% seem out of line. This conundrum presents a meaningful challenge to bond investors trying to preserve purchasing power in the face of persistent inflation pressures and rapidly changing central bank expectations.
So, what are we doing in our fixed-income strategies to manage through this period of volatility? To borrow a sports analogy, the best offense is a good defense.
- Our first line of defense has been duration management. Most of our strategies came into the year modestly short duration. The recent backup in yields provided an opportunity to cover some of these shorts, but our bias remains cautious with respect to duration and we would likely reset shorts if bond prices were to rally again.
- Our second line of defense is using diversified sources of income in portfolios where possible. When fixed-income volatility increases, it’s critically important to diversify sources of income so cash flows can be reinvested on a steady and regular basis. As most fixed-income investors know, the power of compounding interest is the primary driver of portfolio returns.
- Our third line of defense is using Treasury Inflation-Protected Securities (TIPS) and floating-rate structures, where possible. To be fair, U.S. TIPS are very expensive and do not offer great value at the moment, but they can provide good protection as a hedge against higher-than-expected inflation. In addition, floating-rate bonds and loans should perform nicely if the Fed truly does embark on a rate-tightening cycle.
- Our fourth line of defense is “spread product,” which are bonds that trade at a yield higher than U.S. Treasuries (that is at a spread to U.S. Treasuries). This includes corporate bonds, mortgage-backed securities, structured products, and loans. Economic fundamentals should be quite favorable to the creditworthiness of non-government-related borrowers. In addition, bond supply should decline as borrowers reduce the amount they borrow as the cost of the debt rises. Furthermore, the “real” cost of debt remains extremely low, and often negative, for many borrowers. However, tighter monetary policy will eventually erode creditworthiness as the cost of debt rises and availability of debt is constrained. To be clear, we do not believe we are at that point in the cycle, and we still favor holding various forms of spread product in most of our portfolios, but we have been steadily reducing those allocations over the past six months and moving up in quality in anticipation of less favorable borrowing conditions. Our deep fundamental research is laser focused on evaluating cash flow certainty and possible pressure points for each borrower over the coming months and years.
- Finally, our fifth line of defense is positive real yields. Given the current rate of inflation and level of interest rates available in the market, this is hard to come by. But, we continue to look for bonds and issuers that offer positive real yields to help offset the erosion of purchasing power in other parts of the portfolio. Short-duration high-yield bonds and leveraged loans are two segments of the fixed-income market that currently offer positive real yields (versus medium-term inflation expectations) and are in the cyclical sweet spot economically.
At some point, hopefully in 2022, we would like to pivot from defense to offense in our fixed-income strategies, but we recognize that the favorable economic tailwinds of late 2020 and 2021 are likely to fade in 2022 and turn to headwinds. Our objective is to position portfolios to be nimble enough to capitalize on market dislocations when they occur and recoup any mark-to-market losses incurred due to higher rates. When coupled with a steady stream of diversified income, we believe our portfolios are well positioned to weather volatility in 2022.
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