Bonds Commentary

Less for More

September 2020

On August 27, Federal Open Market Committee (FOMC) Chair Jerome Powell made a speech to the Kansas City Fed’s annual Jackson Hole symposium in which he announced a shift in the FOMC’s inflation strategy, with the FOMC now targeting an average inflation rate of 2.0 percent “over time.” This shift was well-telegraphed and shouldn’t have come as a much of a surprise to market participants, but what was news was how, going forward, the Committee will assess monetary policy in the context of “shortfalls from” as opposed to “deviations from” full employment This has led to speculation that the federal funds rate could potentially remain at the zero-bound far longer than most, including us, might have anticipated. Treasury yields in the 10- to 30-year portion of the curve initially moved higher on the news to levels last seen in June as the FOMC’s announcement proved to be more dovish than even the most dovish of expectations. Still, the initial backup in rates proved short-lived as long-dated Treasury yields were again back to pre-symposium levels as of the first week of September.

Despite current low yields, Treasuries can continue to play a valuable role within the core fixed income portion of multi-asset portfolios to help mitigate portfolio drawdown and provide a buffer against selloffs in risk assets such as equities and corporate credit. That said, yields across the Treasury curve are at or near all-time lows, providing little cushion against even a modest rise in interest rates driven by a more constructive economic growth outlook and/or rising inflation expectations into 4Q and year-end. Notably, the Bloomberg Barclays U.S. Aggregate Bond Index, a commonly used benchmark for core fixed income managers, carries a duration of over 6.5 years, a level last eclipsed in the 1970’s, while carrying a yield-to-worst (YTW) of just 1.1%, implying that investors in many index-linked fixed income products are being forced to take on sizable interest rate risk for a lower expected return. This is the source of the “less for more” tagline in the title as investors are receiving less compensation, i.e. yield, for taking on more interest rate risk in their portfolios.

Treasuries could experience outflows over coming months as economic momentum builds and demand from abroad, specifically China, wanes, potentially leading yields to trend grind higher into year-end, a move that could be intensified should economic growth and/or inflation expectations surprise to the upside. After an impressive four-plus month rally from late-March lows, investors in investment-grade (IG) corporate bonds booked some profits and rotated into riskier, higher yielding issues in August. While the Bloomberg Barclays U.S. Corporates index fell 1.3% the Bloomberg Barclays High Yield (HY) index fared much better, rising 0.9% during the prior month. Entering September, the IG corporates index was higher by 6.9% year-to-date, while HY lagged meaningfully, generating a total return of just 1.6%. There are limits to investor generosity, however, and even in a liquidity-fueled environment at some point they begin to balk at low yields. 1.8% on IG corporates and 5.2% on HY corporates appears to be the ‘line in the sand’ at present.

As boring as it may sound, diversification remains of paramount importance in the current environment as yields on ‘safe’ and ‘risky’ instruments alike appear paltry. Our preferred positioning remains a mix of Treasuries, high quality corporate bonds, and asset-backed securities which form a solid ‘core,’ while riskier, higher yielding corporate bonds and U.S. dollar denominated emerging market debt provide some additional yield pickup, but also inject volatility into a portfolio and must be appropriately sized.

Source: Bloomberg, Factset


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