A Good time to Check Your Bond Portfolio

by on October 1, 2014

Bond market and currency volatility have been on the rise lately, leaving many investors wondering what they should do in response.

My take: I’ve been advocating for a while that investors should rethink their fixed income exposure, given that bond investing today is very different than it was in the past.

It’s never accurate to describe investing — whether asset allocation or beating a benchmark — as “easy.” That said, it’s fair to say bond investing used to be “easier.”

For more than three decades, bond managers had the enviable advantage of consistent tailwinds: falling inflation and declining real rates. While bond markets would still suffer the occasional gyration, those dislocations occurred against the backdrop of a multi-decade bull market and steadily declining volatility.bond

Some of those conditions, notably low inflation, remain in place, but the overall environment is less hospitable than it was a decade ago. Today, bond investors face several significant challenges, all of which are likely to impact both the expected return, as well as the riskiness, of bond funds:

Historically low rates, both nominal and real. Traditional bond market aggregates are overwhelmingly weighted toward U.S. government bonds. While Treasury yields are up roughly 100 basis points (bps) from their all-time lows, both nominal and real yields are still a fraction of their long-term average. For example, 10-year Treasury real yields are roughly 50 bps, versus their long-term average of five times that level.

Even before accounting for taxes, investors are receiving little return after inflation, unless you believe that inflation will fall even further from already soft levels. Compounding the problem, yields are even lower in other developed countries. Comparable yields on German bonds are roughly 1% and in Japan, comparable yields are 0.5%.

What’s driving the low yield environment? While extraordinary monetary policy has played its part, today’s low yields are largely a reflection of low nominal growth throughout the developed world. To the extent that demographic and other long-term factors are responsible, this phenomenon is likely to continue in the years ahead, and rates are likely to remain relatively low by historical standards.

Tight spreads. Low yields in the sovereign bond market have pushed more and more investors into other fixed income segments, including riskier instruments such as high yield and emerging market debt.

While these asset classes still offer higher yields than government bonds or investment grade corporates, a multi-year bull market in high yield means spreads are tight and yields are well below average. Even in emerging markets debt, an asset class that many investors shunned earlier this year, spreads have tightened and yields have dropped. The bottom line: Even for investors willing to take on incremental risk, the pickup in yield offered by traditionally riskier segments is less than it used to be.

Prospect for rising short-term rates. While long-term rates remain stable, short-term rates are set to rise next year in the United States as well as in the United Kingdom. Given the recent acceleration in the U.S. recovery, it’s possible that rates may rise earlier and at a brisker pace than many expect.

While this would likely help boost cash returns, it also means that bond investors may face losses. Bonds or bond funds with two- to five-year maturities (those most sensitive to changes in Federal Reserve (Fed) policy), have already witnessed increasing volatility just on the anticipation of a change in U.S. monetary policy.

Implications for Investors

All of the above suggests that investors should reconsider their bond market portfolios, if they haven’t already.

To be sure, there’s still an important place for traditional bond funds in a fixed income portfolio. While they’re light on yield, they can dampen portfolio volatility and offer a much needed hedge against an increasingly expensive equity market.

But in today’s less hospitable environment, investors should consider adopting a flexible approach for at least a portion of their bond portfolios.

With yields likely to be volatile, and some areas of the bond market feeling the effects more so than others, investors will want the ability to adjust their duration or rate exposure tactically (some extra duration actually helped during the first half of 2014). They’ll also want the ability to pursue niche areas of the bond market that still offer an attractive return-to-risk ratio.

A flexible approach, otherwise known as unconstrained investing, that looks for opportunities across a wide set of asset classes and markets can make such on-the-fly adjustments as needed. In short, it can potentially help investors with the increasingly difficult, but still critical, task of bond investing.

Sources: Bloomberg, BlackRock research

Russ Koesterich, CFA, is the Chief Investment Strategist for BlackRock and iShares Chief Global Investment Strategist. He is a regular contributor to The Blog.

Fixed income risks include interest-rate and credit risk. Typically, when interest rates rise, there is a corresponding decline in bond values. Credit risk refers to the possibility that the bond issuer will not be able to make principal and interest payments.

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