Bonds Commentary

No Silver Bullet

November 2020

Investors seeking yield/income find themselves in a difficult position – accept current low yields on ‘safe haven’ bonds, with the knowledge that total return could fall short of inflation if interest rates farther out on the yield curve rise even slightly over coming quarters. Or another equally unappealing option, reach for yield in riskier segments of the bond market and hope that backstops from the Fed and Treasury currently in place stay that way for some time to come, propping up prices of corporate credit and limiting potential drawdown. Neither alternative sounds all that great, but that’s the conundrum we’re facing and attempting to solve for in our portfolios. Investors with long-standing allocations to fixed income have likely maintained that exposure for good reason(s) - often some combination of income replacement, volatility reduction, and/or capital preservation over appreciation, and despite being forced to accept lower yields, the motivation behind holding bonds in the first place likely remains the same.

Investors are increasingly being tempted, if not forced, to reach for yield in riskier segments of the bond market, and while we understand the appeal, higher yields/expected returns don’t come without acceptance of greater potential drawdown, heightened volatility, and a higher likelihood of issuer default. Silver bullet solutions to the yield/income puzzle currently facing bond investors are few and far between, and we would question the motives and methods of those stating otherwise, but there are ways to mitigate potential portfolio pitfalls that could lie ahead stemming from upward pressure on long-term Treasury yields stemming from increased government spending over coming quarters/years.

First, tweak allocations around the edges, taking advantage of opportunities the market presents, while avoiding wholesale portfolio shifts/changes. Second, remain diversified across fixed income sub-asset classes, sprinkling in exposure to asset-backed securities, dollar-denominated emerging market debt, and potentially other areas as well while maintaining a below-benchmark allocation to long-dated Treasuries. Third, maintain a duration below that of the Bloomberg Barclays U.S. Aggregate (Agg) Bond index to lessen interest rate sensitivity given our expectation that long-term Treasury yields could continue to climb, albeit at a slower pace under divided government versus what may have materialized under a Democratic sweep. A strategic framework continues to guide our decision making, and we believe a more measured approach will serve investors well, while limiting the potential for unintended portfolio impacts to occur from taking on increased risk without fully understanding the trade-offs.

We have pulled forward fixed income returns over recent years as the Bloomberg Barclays U.S. Aggregate Bond index has annualized a 5% return over the trailing 3 years and a 4% return over the trailing 5 years ending October 31, 2020. When we published our 7 to 10-year capital market return assumption for the Agg in both 2015 and 2017, we expected a 3% annualized return over the next decade. The Agg would need to generate a 2% annual return over the next 5 years to hit our original 3% assumption, and with a yield-to-worst of around 1.25% at present, even 2% might be a stretch. Rising interest rates would act as a headwind for investors already heavily allocated to fixed income, but for investors with cash seeking safe income, even a modest move higher in long-term Treasury yields would be most welcome.

Source: Bloomberg, Factset


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