The fixed income game is changing rapidly. Here is your new playbook.
Advisors are now busy doing quarterly portfolio reviews with clients and, as Desi once told Lucy, they have a lot of explaining to do. Not only are many equity positions in the red for 2022, but the typical fixed-income haven doesn’t feel so safe.
Bonds suffered their deepest fall in the first quarter in many years. Many advisors were well-prepared, avoiding “duration” or interest rate risk, which helped avoid the double-digit losses recorded by long-term bond funds such as the iShares 20+ Treasury ETF Bond (TLT). That pain continues as the 10-year Treasury bond rose to 2.75% from just 2.4% in early April.
Even seemingly ultra-safe bonds, such as those that hedge against inflation and rising interest rates, have not held up. the
iShares TIPS Bond ETF
(TIP), for example, has lost almost 5% since the start of the year, according to
the morning star
Why would a fund that ostensibly benefits from rising inflation lose value, even though inflation has recently accelerated? Because the value of these funds may be negatively affected when investors believe that inflation will start to subside in future periods. Indeed, chatter about an impending recession within the next 12 months is now on the rise on the desks of Wall Street strategists.
Two-pronged attack on inflation. Admittedly, the Federal Reserve quickly moved from a seemingly accommodating approach to inflation to a very aggressive one. Not only are benchmark interest rates poised to rise with every meeting of the Federal Reserve Open Market Committee (FOMC), but some of those hikes will likely be half a percentage point. This is likely to provide serious shock therapy to the economy and inflation.
Yet it will be efforts to shrink the Fed’s balance sheet that could really confuse bond markets. Nearly $9 trillion in seed money since the start of 2020 has helped drive bond yields down to historic lows. Now Fed Governor Lael Brainard is suggesting that there is a clear need for the Fed to reduce its balance sheet “quickly”.
Rapid rate hikes, along with quantitative tightening (QT), could slow the economy faster than many realize as liquidity conditions tighten. Consider that the Fed’s $9 trillion in assets is about 40% of annual GDP.
Barrons Lisa Beilfuss recently presented a worrying scenario of a gradual reduction in assets held by the Fed, at a time when the US budget deficit remains quite large. Traditional buyers of items such as mortgage-backed securities and general US government bonds, such as banks, insurance companies and pension funds, will have to engage in massive purchases of instruments of debt that are offloaded by the Fed, even though they are supposed to fund government red ink through Treasury auctions. If they are reluctant to do so at lower rates, then Beilfuss asks “how low should prices go and how high should yields go?”
This kind of scenario was in place when “bond vigilanteswreaked havoc on fixed income markets in 1994, pushing yields higher and bond prices crashing.
Emerging opportunities. Rising yields may cause misery for current bondholders as prices fall, but creates openings for investors looking to earn more attractive yields from new issues. In the short-term of the bond market, look for rising returns on commercial paper funds such as the iShares Floating Rate Bond ETF (FLOT) or on lower-duration bond funds such as the Vanguard Short-Term Bond ETF (BSV ).
We could also see attractive opportunities emerging in medium to long-term bond funds, despite an expected rise in short-term rates. Note that the Fed’s goal is to cap inflation by slowing the economy, so unless we get the “bond vigilance” scenario just mentioned, longer rates should rise much more slowly. as the economy cools.
So far, advisors have avoided duration by avoiding bond funds with longer average maturities. But they should ask clients the following question: “How willing would you be to accept a decline in the value of your bond holdings now in exchange for higher returns in years to come?” I’ve had this discussion with my clients and they generally seem receptive to compromise.
Many bond funds ladder maturities and can buy new bonds at higher rates as older issues mature. Mark Hulbert, who writes for Barrons and MarketWatch, noted last fall that a buy-and-hold approach during periods of rising rates will pay off if your holding period for a mid-term or long-term bond fund is “one year less than twice the average bond duration (funds)”. If you really want to dig deeper into this strategy, you can read the academic article who supported him in 2015.
In my opinion, this approach makes perfect sense for 2022, and not for a theoretical future calendar. Yes, we know that interest rates will rise, perhaps to a considerable extent, although we also know that rising short rates will likely cause long rates to rise more slowly (leading to an inverted yield curve at whole). Simply put, we don’t have a crystal ball for the dynamics between long and short rates in the months ahead. Yet, as Hulbert notes, anyone willing to take on the duration now will be amply rewarded, if they have a multi-year time horizon.
And while I generally prefer passive funds for my clients, I look for actively managed funds when it comes to international bond funds, many of which offer higher yields than domestic bond funds with similar credit quality and duration. the
BlackRock Institutional Strategic Global Bond Fund
(MAWIX) earns a five-star gold rating from Morningstar, as does
Dodge & Cox Global Bond
Even as advisors help clients understand why their bond fund holdings have fallen so far in 2022, it’s time to shift the discussion to the emerging yield opportunities ahead.
David Sterman is a journalist and registered investment adviser. He is running Huguenot financial planninga fee-based financial planning company based in New Paltz, NY.