As resolutions go, rethinking your fixed-income portfolio may not resonate in quite the same way as dropping 10 pounds or finally giving up that smoking habit. But if ever there was an opportunity to reassess how you approach bond investing, now is the perfect time.
Last year our lead theme of How I Stopped Worrying and Learned to Love the Bond favoring longer-maturity debt was right, even if for the wrong reasons. We thought rates would go up but long bonds would outperform; the latter was correct but the former clearly was not. This year our lead theme All About That Pace again appears out of consensus as the market view for rates has shifted towards fears of deflation and expectations that low global rates means U.S. rates can never move higher. The latter part of the year also brought plenty of financial-market volatility—a trend that is likely to continue in 2015. If persistent zero interest rates and quantitative easing that were intended to lead investors to take more risk in pursuit of higher yielding assets led to dampened volatility, we should expect greater financial market volatility in 2015 as the Fed pulls back from its zero rate policy.
It’s partly because of that volatility that fixed-income investors need to reassess their commitment to bonds. Always keep in mind what role bonds play in your portfolio:
- Diversification: Use traditional bond strategies to diversify equity exposure.
- Source of Protection: Use flexible bond strategies to guard against interest rate and credit events.
- Income: Use yield-focused solutions to help generate income.
The benign environment of the past six years has bred complacency in investments expected to have the least amount of risk. This is particularly the case for bonds that, in today’s zero interest rate environment, have commonly been used as surrogates for cash. That complacency should now be challenged if the outlook that the Fed is finally going to raise rates is realized. Our shorten your duration but don’t own short duration theme captures this idea. Higher yielding strategies have been rewarded in the past, but those yields result from greater interest rate or credit/illiquidity risk, or both.
While reaching for yield has been successful in the past, we suggest increasing credit quality, increasing liquidity and reducing risk in an environment where the Fed’s policy changes introduce a very different forward-looking outlook. That different outlook is captured in the figure nearby highlighting how the downside risks to bonds—in this case looking at short duration bonds—is masked in an era of zero interest rate policy but is revealed when the Fed begins raising rates.
No Longer a Cash Alternative: Risks in Short Duration Expand During Hiking Cycles
Also keep in mind that flexible bond strategies have the potential to outperform in rising and flat interest rate environments, and can help provide meaningful diversification, which may reduce overall volatility in a portfolio. Their greater flexibility allows the implementation of many of our key outlooks this year: yields that move in very different ways depending on the maturity, as front end rates lead higher rates from Fed policy changes, but back end rates look vulnerable from overpricing fears of deflation. Decoupling bonds from their currency risk in Emerging Markets as well represents another favored strategy that flexible bond strategies can employ to help investors navigate a more volatile investment environment in 2015.
When the Fed does raise rates—and we expect that in June—then the largest impact will be felt in the shortest maturity yields. The historical record shows that even though this should not be any “news” to anyone, the bond market inevitably tends to overreact. The result is an increase in short-term interest rates beyond what is currently reflected in market expectations and the consensus view, leaving our 2-year forecast a bit higher at 1.75%.
And higher short-term interest rates is one reason we disagree with market consensus concluding that a world of low interest rates means the 10-year can never rise. We believe that when the Fed starts raising rates in the front end it will want to see long-end rates rise as well. This is to both avoid over stimulating the housing market (a mistake they now admit occurred during the last cycle) and to avoid the negative signal of inverting the yield curve. And though the market may have forgotten it, the Fed has $4.5 trillion reasons to make sure that outcome occurs. That leaves us expecting modest increases in the 10 year rate to 2.5% for year-end 2015.