The Bond Investors' Dilemma
So far, 2019 has been a very good year for bond investors. Total returns in the fixed income markets have been among the strongest in the last 10 years, driven by declines in both interest rates and credit spreads.
As the end of the year approaches, many investors may look to rebalance portfolios—that is, sell top-performing assets and invest the proceeds in lower-performing ones, to bring the portfolio back to its target asset allocation. It’s a good idea to do this on a regular basis.
However, with Treasury bond yields near all-time lows, many are reluctant to reinvest in longer-term bonds, but are concerned about the risks in higher-yielding, lower-rated bonds. Meanwhile, sitting in very short-term investments could mean lower income if short-term rates decline. What’s an investor to do?
Fixed income total returns have been strong year to date
The answer to the question comes down to the economic outlook. Notably, the bond market’s view is decidedly gloomy, but the Federal Reserve and equity market’s outlook seems to be more optimistic.
Bond market gloom
Slowing global growth, especially in the manufacturing sector; expectations for more easing by central banks; and declining inflation expectations suggest a near-recessionary outlook. There is currently more than $14 trillion in negative-yielding bonds across the globe, and at least five major central banks have reduced policy rates to zero or below zero.
In the U.S., the 10-year Treasury yield has fallen from a peak of about 3.25% late last year. The downtrend accelerated in the spring, causing the yield curve to invert—with long-term rates falling below short-term rates—which historically has often been a signal of recession in the next year.
An inverted yield curve and recessions
Moreover, signs of concern about the economic outlook have emerged in the credit markets, with the performance of the lowest-rated corporate bonds diverging from higher-rated bonds. Investors are requiring higher yields for the bonds in the lowest tiers of the high-yield market, reflecting the concern that a weakening economy could lead to an increase in defaults.
Lower-quality Caa-rated bond returns are lagging those with higher ratings
Declining inflation expectations also reflect the bond market’s downbeat outlook. Various measures such as the breakeven rate for Treasury Inflation-Protected Securities (TIPS) or the 5-year/5-year forward rate for Treasuries suggest the market is pricing in a lower rate of inflation in the future.
TIPS breakeven rates are below the Fed’s 2% inflation target
The Federal Reserve is upbeat
In contrast, the Federal Reserve’s outlook is more upbeat. Although the Fed has lowered short-term interest rates twice this year, its forecasts continue to signal expectations for firmer growth and inflation, and there is a lack of consensus among Fed officials about the need to ease policy further. As of September, the Fed’s median estimate projected no more cuts through the end of the year, but there’s a wide range of projections; seven officials do project one more cut this year. The Summary of Economic Projections indicated that gross domestic product growth would continue near the 2% level and that inflation would edge higher next year.
Differences between what the markets expect and what the central bank expects always get resolved eventually. While the market generally has had a better track record of forecasting the Fed’s actions in the past few years, we think it would be a mistake to be complacent. Many of the factors holding back economic growth are policy driven, such as uncertainty about the outcome of trade negotiations, which means the outlook can change abruptly.
What’s an investor to do?
We suggest investors temper expectations about returns in the fixed income markets. While we still expect most bonds to post positive returns in 2020, it is likely to be driven more by the bonds’ coupon payments rather than price gains. Over the long run, we believe staying invested leads to better outcomes for investors. For example, investors who have been keeping a lot of their fixed income allocation in cash over the past year, due to the fear of rising interest rates, missed out on the income and gains generated in the market. Moreover, high-quality bonds such as Treasuries or investment-grade municipal bonds should serve as a ballast for a portfolio by reducing volatility, especially when the stock market declines.
Here are a few steps to consider when rebalancing a portfolio:
To mitigate the impact that a recession might have on a portfolio, we suggest reducing exposure to the riskier segments of the market, such as high-yield bonds.
To mitigate the risk of rising interest rates, we suggest using a strategy like a bond ladder to spread out the maturities over time.
To mitigate the risk that inflation surprises to the upside, consider adding TIPS to a portfolio. Current breakeven levels are below the Fed’s 2% inflation target and the 10-year average is indicating they’re attractively priced relative to historical averages and the Fed’s inflation target.
Follow Kathy Jones on Twitter: @KathyJones
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A bond ladder, depending on the types and amount of securities within the ladder, may not ensure adequate diversification of your investment portfolio. This potential lack of diversification may result in heightened volatility of the value of your portfolio. You must perform your own evaluation of whether a bond ladder and the securities held within it are consistent with your investment objective, risk tolerance and financial circumstances.
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The Bloomberg Barclays US Aggregate 1-3 Year Bond Index includes investment grade, US dollar-denominated, fixed-rate taxable bonds with maturities of between 1 and 3 years.
The Bloomberg Barclays US Aggregate 5-7 Year Bond Index includes investment grade, US dollar-denominated, fixed-rate taxable bonds with maturities of between 5 and 7 years.
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The breakeven inflation rate is a market-based measure of expected inflation. It is the difference between the yield of a nominal bond and an inflation-linked bond of the same maturity.
5 Year 5 Year Forward Inflation Expectation Rate is a measure of expected inflation (on average) over the five-year period that begins five years from today.
Diversification and rebalancing a portfolio cannot assure a profit or protect against a loss in any given market environment. Rebalancing may cause investors to incur transaction costs and, when rebalancing a non-retirement account, taxable events may be created that may affect your tax liability.
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Treasury Inflation Protected Securities (TIPS) are inflation-linked securities issued by the U.S. government whose principal value is adjusted periodically in accordance with the rise and fall in the inflation rate. Thus, the dividend amount payable is also impacted by variations in the inflation rate, as it is based upon the principal value of the bond. It may fluctuate up or down. Repayment at maturity is guaranteed by the U.S. government and may be adjusted for inflation to become the greater of the original face amount at issuance or that face amount plus an adjustment for inflation.
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