Higher U.S. inflation and rising yields have some investors questioning whether they should stick with bonds. Undoubtedly, 2021 is shaping up to be one of the more challenging years for fixed income investments in recent times. Even so, reports of the bond market’s death are greatly exaggerated. It’s no time to listen to the bond bears: Owning bonds in this kind of environment remains as important as ever.
As our colleagues explained in their U.S. outlook and its international counterpart, economic growth is expected to be strong. However, that strength will not be uniform across regions and sectors. The recovery has global policymakers on both the fiscal and monetary side curtailing their unprecedented COVID-19 stimulus. For central bankers, in particular, that normalization process will likely be quite gradual. They must consider the risk of upsetting the financial market as the recovery unfolds.
The Fed’s slow unwind will be driven by inflation and employment
Although inflation has hit the U.S. Federal Reserve’s 2% target, full employment remains far from its goal. The central bank has communicated that it will endure inflation above target for some time. It sees this target as an average, not a ceiling. Inflation averaged below that level until recently.
In the Fed’s June meeting, monetary policymakers shifted their projections for 2023 from zero to two 25 basis point hikes. We believe the central bank is likely to follow through accordingly, assuming that unforeseen negative factors don’t throw labour market and broader economic recoveries off track. The Fed could begin to slow, commonly referred to as “taper,” its asset purchases as soon as later this year.
Currently, temporary pandemic-driven supply shortages and pent-up demand dynamics appear to be driving higher prices. But the unprecedented level of fiscal and monetary stimulus paired with some structural changes such as demographic trends could result in more persistent above-average inflation.
Markets have accounted for increased probability of sustained inflation in recent quarters, which helped to push up longer term U.S. Treasury yields earlier this year. After recording an all-time low of just 0.51% last August, the 10-year Treasury yield peaked at 1.74% in the first quarter of 2021. Since then, the benchmark rate has settled in a range around 1.5% but remains well above 2020 lows.
Although yields may climb farther, we see their ascent as likely to be gradual. That’s partly due to our view that the Fed’s tightening will be measured. But we also see other factors at play. One example is demand by global investors. Many find U.S. yields relatively attractive even after hedging for their home currencies.
Despite the recent rise in inflation and yields, investors’ long-term perspective should not change. We believe, for those seeking balance, fixed income remains essential and should be approached three ways.
As June 2021 began, investors were sitting in US$4.6 trillion in U.S. money market funds. Their jitters related to fixed income investing in this challenging environment are understandable. However, holding cash or cash-like investments amid higher rates of inflation may not be a favourable investment strategy. In fact, second-quarter cash holdings missed out on positive returns in most bond sectors while taking a hit to purchasing power thanks to higher inflation. Investors willing to accept a modest amount of credit and interest rate risk could find high-quality shorter term bond funds a better option.
Equities have hit new highs in recent quarters. As the recovery continues, so may this positive trend. However, a significant amount of upside is already reflected by current valuations. That means any negative news or setbacks could produce volatility should investors be forced to rethink some of their optimism. Put another way, in an environment when higher risk asset values are soaring, having a strong core bond allocation is as important as ever. This has the potential to provide all four roles of fixed income: Diversification from equities, capital preservation, income and inflation protection.
That last role might be at the forefront of some investors’ minds, given the trend in consumer prices. An actively managed core bond fund has the ability to invest in inflation-linked products, which can help preserve purchasing power if inflation picks up.
But what about the potential for yields to drift higher? Does that mean capital preservation will fail? Historically, investors who owned high-quality core fixed income generally fared well over a medium-term perspective. Consider the five periods of sharpest yield increases over the past three decades. Following these spikes, two-year returns were positive for the U.S. core bond benchmark, the Bloomberg Barclays U.S. Aggregate Bond Index.
Core fixed income has notched gains following the sharpest yield spikes over 30 years
Of course, rising yields are ultimately good news on the income front. As yields gradually increase over time, so will bond fund income. Bond funds focused on high-quality securities may also help to soften the impact of volatility on a broader portfolio. Look for a fund that has maintained a low correlation to equities by having a return pattern that is not closely tied to that of stocks, such as our core and core-plus bond funds.
Corporate bonds have felt the positive impact of the strong economic expansion. However, we believe that much of the upside has already been priced into risky asset values. Consider the premium investors are currently paid for corporate bonds over U.S. Treasuries. These credit spreads for both investment-grade and high-yield bonds have tightened to pre-pandemic levels, which were already extremely low from a historical perspective.
Tight credit spreads show the need for selectivity
Just because credit sectors now look expensive doesn’t mean managers can’t find opportunities. It means they must rely on research to unearth better relative values for investing. A multisector approach can provide the flexibility to pursue the best relative values across varying types of bond issuers. Portfolio managers the ability to pivot to sectors that research highlights as markets evolve. By blending higher income sectors, investors can also potentially capture more yield while reducing the overall volatility of their portfolio.
The second half of 2021 and beyond is likely to be a more challenging period for fixed income than some investors are accustomed to. But the importance of maintaining a balanced portfolio hasn’t changed. With lofty valuations across many asset classes, having a high-quality fixed income allocation that provides all the roles of fixed income remains essential for investors striving for long-term success.
Bloomberg Barclays U.S. Aggregate Bond Index represents the U.S. investment-grade fixed-rate bond market. Bloomberg Barclays U.S. Corporate Investment Grade Index represents the universe of investment grade, publicly issued U.S. corporate and specified foreign debentures and secured notes that meet the specified maturity, liquidity and quality requirements. Bloomberg Barclays U.S. Corporate High Yield Index covers the universe of fixed-rate, non-investment-grade debt.
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