Bonds have gone from the “sleep at night” portion of investors’ portfolios to a source of anxiety. Due to the latest shift in Federal Reserve policy, finding income in bonds has gone from being exceedingly difficult to nearly impossible, and finding safety in them might be increasingly elusive. Investors in these securities need a new approach—and a reset in expectations.
“The fixed-income portion of a portfolio used to be where you got safety and income,” says Steven Wieting, chief investment strategist at Citi Private Bank. “Now, you can get one or the other—and even the safety portion can become a portfolio danger.”
The reasons are many, but as with most trends in fixed income, it all starts with the Federal Reserve. The Fed indicated in September that it would keep interest rates at near zero for at least three more years. This marked a dramatic shift in its framework for interest-rate policy, signaling that it wouldn’t raise rates until the job market has fully recovered and inflation has reached 2%—and is on track to moderately exceed that level for some time. That itself is unsettling for yield-dependent investors. Complicating the situation further: The Fed’s unprecedented stimulus to deal with the pandemic, such as expanding its bond-buying to include corporate and high-yield paper, has pushed valuations to highs and left income-starved investors with a scarcity of options.
Investors got a taste of how high prices, low yields, and a short supply of bonds could pose a danger when the part of their portfolio that should hold up relatively well logged losses during the height of the crisis: Core bond strategies lost 3%, on average, between mid-February and mid-March, according to Morningstar. As investors try to digest all the “historic” and “unprecedented” developments, the message is that “everything has changed,” says Mary Ellen Stanek, the chief investment officer at Baird Funds.
“The Fed’s moves have eliminated the upside in an array of high-quality assets, creating an extraordinary demand for yield. That’s made the 40% in a 60/40 [stock/bond] blend dubious as a hedge and for returns,” says Rick Rieder, chief investment officer of BlackRock’s $2.4 trillion global fixed-income group and co-manager of the BlackRock Strategic Income Opportunities fund (BASIX). “If you are holding the same portfolio as two years ago and expect it to do the same, it won’t. You have to restructure how you think about asset allocation, especially fixed income.”
In some ways, the situation confronting U.S. investors is even worse than what Japan faced during its long deflationary slog. “It’s not a comfortable position. People point to Japan, where yields stayed low for a long time. But real [inflation-adjusted] yields there were actually positive, because Japan had deflation. We don’t. Our yields are negative! It’s not an attractive time to be invested in traditional fixed income in its most basic form,” says Sonal Desai, chief investment officer for Franklin Templeton’s $148 billion in fixed-income assets.
Bond managers are expecting just half the return they got a few years ago, while enduring more risk to get there. After the 2008-09 financial crisis, bond investors could have generated real returns (returns minus the inflation rate) of 3% to 5%; today, they can expect less than 3%—and that’s before inflation. “Investors should probably form their retirement expectations around where that yield is,” says John Hollyer, global head of Vanguard’s $1.9 trillion fixed-income group.
With interest rates in much of the developed world at zero, investors are left with two unappealing choices: own longer-dated government bonds, which can be risky since their prices fluctuate more with any interest-rate changes than do shorter-dated ones, or own bonds that offer higher yield because the issuers have more risk of default. Managers say the extra income for owning longer-term bonds doesn’t amount to much, so that leaves them advocating a “barbell” approach: The best bond portfolios for today’s economic environment have one end in low-yielding, but high-quality, assets that might earn negative yields after inflation is factored in, but will act as a buffer when the market is volatile. The other end is in higher-yielding bonds, stocks, and some alternatives that can provide income.
Barron’s spoke with several veteran bond managers to learn which risks they’re monitoring, how to balance safety and yield, and why so many of them are recommending stocks.
Record-low interest rates and Fed bond-buying were mainstays of the last financial crisis. But this time, rates are starting from a lower level, and because of the Fed’s purchase of far more than just Treasuries, there isn’t all that much to purchase. “We will get back to a market driven by economic fundamentals,” says Vanguard’s Hollyer. “For now, it’s policy.”
Valuations are stretched, and that’s before an actual recovery takes hold, says Dan Ivascyn, a group chief investment officer for Pimco, which oversees $1.9 trillion in assets. High valuations are inherently risky, since prices will fall when the market starts valuing assets based on their intrinsic value—but this is especially problematic against today’s polarized political backdrop. For example, the fund managers whom Barron’s spoke with say a $1 trillion fiscal package is necessary for an economic recovery, but that package is caught up in political wrangling. Political jockeying that leads to less fiscal stimulus than what the economy—and markets—are relying on is “absolutely” a risk over the next couple of months, Ivascyn says.
The November election also poses more danger than usual. A change in administration could mean significant regulatory or tax shifts, and there is also the possibility that there’s no clear result on election night, or even far beyond it—not to mention the uncertainty created by President Donald Trump testing positive for Covid-19. That could create market volatility amid a type of uncertainty that central banks can’t do much about, Ivascyn says. The preferred hedge is longer-term Treasury bonds, but investors may also want to diversify with some gold or Japanese yen, given that the nexus of the uncertainty will be the U.S., Desai says.
Investors are more concerned about economic risk, however. Even if a fiscal package passes, most expect a bumpy recovery. “I don’t think we get back to late-2019 levels of growth until some point toward late next year or the beginning of 2022,” Ivascyn says.
Baird’s Stanek worries that economic growth could stay lower for longer than people expect, despite the sharp bounce off the bottom. “It’s going to take years before we get back to where we were in terms of unemployment,” she says. Given the Fed’s emphasis on full employment, that could mean rates could stay low for a while.
Today’s economy will leave scars, many professional investors agree, and their chief worry is what form they will take. While the U.S. has recovered half of the jobs lost during the pandemic, Desai is keeping a close eye on whether cities reimpose restrictions on businesses, and watching how the services sector can recover if the virus is still present. Desai expects more corporate defaults over the next six to 12 months.
Some managers fear that the economic pain might not be fully reflected in the bond market. “Yield spreads are just a bit wider than at the beginning of the year. In our mind, there’s a lot more risk,” says Warren Pierson, Baird’s deputy chief investment officer and co-manager of the Baird Aggregate Bond fund (BAGIX).
Dan Fuss, vice chairman of Loomis, Sayles and co-manager of the $9 billion Loomis Sayles Bond fund (LSBRX), is also worried about credit risk in weaker companies and emerging markets, noting that liquidity could be masking underlying problems in some of the bonds that are doing relatively well right now. Another area Fuss worries about: Parts of the collateralized loan obligation, or CLO, market, where the ties between lenders and borrowers aren’t as strong. “The lender’s incentive is to make the loan if they have a buyer for it on the other side,” Fuss says. “These structures were far less prevalent 12 years ago, and that is the underlying weakness in CLOs.”
Fuss, who has been investing in the bond market for 62 years, says the ghost of Milton Friedman has been visiting him in his nightmares, telling him to wake up and warning him that inflation is coming. “When I don’t listen, the ghosts multiply. There’s a chorus now singing so that I pay attention,” Fuss says. “Do I expect what happened in the second half of the 1970s [a sharp spike in inflation that pummeled long-term bonds]? No. But I’m making a huge assumption that the government process works well and the Fed doesn’t get trapped.”
With nearly 13 million people still unemployed, inflation is a longer-term concern. But Rieder says he is more concerned about asset bubbles and financial conditions, which could force the Fed to shift its stance. “When you say interest rates are going to be at zero for a long time, it opens the floodgates to misallocation and investors having to take more risk,” Rieder says.
The other concern, of course, is the rising deficit, which by year end is expected to hit a level not seen since 1943—roughly a quarter of gross domestic product. Bond managers are generally more comfortable with running a big deficit during periods of economic weakness, so long as rates are low. That points to a weaker dollar, however—which is one reason some fund managers are diversifying into foreign currencies. The euro, for example, is looking more attractive after approval of its home region’s 750 billion euro ($878 billion) European Recovery Plan.
Vanguard’s Hollyer downplays the risk of the dollar losing its status as a reserve currency. “There’s no obvious replacement,” Hollyer says. “People worry about debt-to-GDP passing 100%, but being the world’s reserve currency gives the U.S. a tremendous amount of room to carry more debt.”
More concerning is a faster-than-expected recovery, perhaps supercharged by a vaccine that’s available sooner than predicted. Any sign that the Federal Reserve might withdraw its supportive policy could create a burst of selling in the bond market—similar to 2013’s taper tantrum, when bonds fell sharply on the central bank’s announcement that it would dial back its bond purchases. This would be a particularly dangerous situation today, given current valuations, Hollyer warns.
How to invest
You know things are tough in the bond market when some of the most successful fixed-income managers are recommending that investors own more stocks, as well as alternatives, to generate income.
What does that mean for the 60/40 portfolio? The answer depends on an investor’s age and risk tolerance, but Rieder recommends more stocks and, in the bond portfolio, only half in traditional fixed income, with the other half split between alternatives and cash.
Templeton’s Desai has a similar view: “For the next six to 12 months, it’s difficult to say that fixed income is where you should be overweight,” Desai says. “You need to go global and diversify risk.”
Desai also recommends stocks, especially high-quality dividend payers, for the income portion of a portfolio. Other experts agree. “I’m going to look for my income on the stock side, and play defense with bonds,” says Fuss, whose Loomis Sayles Bond fund can own up to 20% in equities. “There’s risk for everything. Looking at the longer-term debt of good drug companies like Pfizer (PFE) and yields are 2.8% to 3%, but the stock yields around 4% and has been bumping up every single year.”
Another favored area: higher-quality municipal bonds, especially for investors in upper tax brackets. While the bargains aren’t as good as they were in the spring, Stanek says what seems like fair value now could look much more attractive if the election brings about changes in tax policy.
The financial strain on cities and states is a concern, and many need federal fiscal help to support a recovery and avoid public-sector layoffs and cuts to essential services. But if that aid isn’t forthcoming, Hollyer says, municipalities will make the necessary cuts to make do, which could be economically painful and trigger downgrades, but not defaults.
Baird’s Pierson describes the muni universe as the “used-car market” of the bond world: While not easy, it is possible to find good value, even in the bonds of troubled cities. Pierson is focusing on bonds from airports and universities: “Some are struggling, but not all are going to default.” There is also some opportunity in high-yield, especially in the roughly $230 billion of “fallen angels,” paper from investment-grade companies that have been downgraded to high-yield status.
Pimco’s Ivascyn says he is looking for additional sources of protection when hunting in the lower-rated parts of the market—such as hard-security or hard-collateral backed investments in more economically sensitive sectors, such as airlines. Ivascyn is also finding opportunities within housing, including select bonds of home builders and debt of more stable real estate investment trusts, noting improving fundamentals and conservative lending practices that came out of the last global financial crisis.
The yield on high-yield isn’t that high, however; spreads are only slightly wider than they were at the beginning of the year, which means the market might not be properly pricing in the risk of possible defaults and downgrades. “You want leveraged companies to grow revenue and grow out of the problem, but a sluggish economy is going to make that hard to do,” Pierson says. “If high-yield goes into defaults, the recovery rate is going to be lower than it has been because of growth in the leveraged-loan market, which is senior to unsecured high-yield debt.” While the Baird Core Plus Bond fund (BCOSX) can hold up to 20% of its assets in high-yield, it has less than 5% there.
Another area investors are approaching cautiously is emerging market debt, particularly from China, as that nation’s economy has bounced back and continues to be a global growth engine. China’s bonds were recently greenlighted to be added to a major global bond index, which will draw more investors. That said, Rieder notes that escalating U.S.-China political and trade conflicts, among other issues, means he is sizing his bets in China carefully.
Alternative investments are another place to look for income. Rieder sees opportunities in infrastructure, including bonds linked to the financing of toll roads, ports, and warehouses, and in mezzanine loans—or subordinated debt that sits between debt and equities—in parts of the commercial and residential real estate markets.
On the safety end of the barbell, “We are looking at quality and liquidity, not yield,” says Pierson, who has been doing that with a mix of Treasuries and government mortgages that are still very liquid, as well as securitized assets, such as the top tier of asset-backed mortgages, commercial mortgage-backed securities, and even some investment-grade corporate bonds.
While 30-year Treasury bonds will still be a haven if investors flee riskier assets or there’s a prolonged downturn, the price of that safety is near historic highs—which makes these securities less safe. “The duration, or price volatility, of the 30-year is the highest volatility in history, making it a potential sitting duck for a Fed that is trying to create more inflation,” Rieder says. Inflation will hurt the 30-year Treasury more than almost any other asset in the world today, Rieder predicts. That’s one reason he recommends owning just half the amount investors normally would.
What else goes into the safe bucket? Loomis’ Fuss favors one- to seven-year ladders of municipal bonds, and short-term investment-grade corporate bonds. Some fixed-income managers also like Treasury inflation-protected securities, or TIPS, which are a relatively cheap alternative. Their longer-than-average duration would benefit from an economic shock or a rout in stocks or credit, and they offer a hedge against inflation, which could be useful, because the Fed has indicated that it will be more tolerant of inflation.
Even some high-yield corporate bonds can be part of the mix. Vanguard’s Hollyer has been looking at lower-quality ones in sectors such as transportation services—think FedEx (FDX)— that are benefiting from e-commerce trends, and paper from auto makers and companies that support the automotive sector, as people buy cars to avoid public transport.
The result of all this is a portfolio for our times—a mix of two extremes that might not ensure a restful sleep, but will let you relax enough to get by.
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