The standard sixty-forty portfolio garnered double-digit returns in 2020 for only the seventh time in the past 20 years. While this also marked the first back-to-back calendar year of double-digit returns since 1999,1 the victory lap didn’t last long. The bond market hasn’t kept up the pace in 2021.
In fact, in February with rates rising, the only broad-based fixed income sectors with positive returns for the month – and for the year – were high yield and senior loans. All other sectors have stumbled out of the box due to duration-induced price declines and the opposite reaction bond prices have when rates rise.
Fueled by accommodative monetary policies and additional fiscal stimulus, higher inflation expectations and upbeat growth prospects will likely keep upward pressure on rates – and, therefore, weigh on core bond portfolios. So how can you position for a higher rate regime?
Bond portfolios have trouble with the curve The yield curve (difference between the US 10-year and US 2-year yield) steepened last month to its widest level since 2018, surging to 128 from 96 basis points at the start of the month. This is all from movements in the US 10-year, as it rose by 34 basis points. Catalysts for these moves include dovish comments from the Federal Reserve2 and the US Treasury,3 a weak demand at the US Treasury auction,4 the House passing Biden’s stimulus bill,5 the FDA backing a third vaccine that will increase supply and potentially move herd immunity closer,6 potential technical selling from risk-parity funds as stock and bond correlations have risen,7 and stronger economic data, illustrated by the trend we have seen in ISM prices, as shown below.
Rates moving higher on the long end has flipped term premiums positive for the first time in over three years, as shown below. This trend is further evidence of the market pricing in higher future growth and inflation levels – and of investors requiring a higher yield as compensation on longer maturity bonds.
A higher rate regime, while beneficial for generating income, likely will continue to weigh on core bond portfolios, however. Duration remains extended and, while rates are higher today than at the start of the year, they offer too little support to offset any duration-induced price declines.
For example, a 50 basis points rise in rates would lead to a total return loss of 2.97%, based on the duration of the Bloomberg Barclays US Aggregate Bond Index (Agg) (6.3 years) and basic bond mathematics. Yet, not all of the Agg’s components would react the same way, as shown below. For example, the rate risk profile for Mortgages (3.57 years duration) is different than what other core bond sectors (US Treasuries, 6.88 years; US IG Corporate Bonds, 8.5 years) offer. And with a yield (1.78%) above core Aggregate bonds (1.53%) and US Treasuries (0.93%), plus lower volatility (2% versus 3% and 4%, respectively)8 , Mortgages may be a valuable overweight in the core.
Gearing up for the next at-bat To the detriment of bond portfolios, and the rest of the sixty-forty portfolio, three catalysts, may keep rates rising:
The Federal Reserve’s actions: The Fed is unlikely to change its accommodative monetary policies aimed at reflating the economy, considering unemployment is still over 6%. If you consider the more comprehensive U-6 measure of unemployment that includes marginally attached workers as well as those working part time, that figure is over 11%, well above where it was a year ago (7%)9. Hard to think the Fed would turn less dovish and not seek to keep reflating the economy with so many out of work.
Fiscal Stimulus: On February 27, the House passed a bill that could lead to $1.9 trillion of fiscal stimulus. Expected to pass in the Senate, the Biden administration wants the stimulus bill to arrive at the president’s desk for signature before March 14 when key provisions from earlier stimulus packages run out.10 Increased spending and more supply of Treasuries to fund it, all aimed at reflating the economy, will put more upward pressure on rates.
The Savings Stockpile Unleashed: The US personal savings is currently 20% of disposable income, as shown below. If not for the record set during the first lockdown last year, this would be the highest percentage ever. This equates to roughly $1.7 trillion more than the pre-pandemic run rate,11 and signals pent up spending that could be unleashed as the economy reopens to usher in higher growth and inflation – trends that can push rates higher.
In terms of inflation, expectations haven’t been this high versus actual levels since 2015, as measured by the difference between CPI and the US 2-year breakeven rates, however. The rise in breakevens is supported by the stimulus programs as well as the fact that the Fed is buying Treasury Inflation Protected Securities (TIPS) as part of its quantitative easing measures and now owns 20% of outstanding TIPS. Therefore, breakevens could be a bit inflated by the central bank’s demand.
Now, the differential between the two inflation measures, could mean two things for the future: 1) expectations get dialed back like they did in 2015 2) CPI begins to play catch up. The latter is more likely, given some of the low base effects, recent increases in oil prices, and stimulus effects discussed above.
A way to take a swing at higher rates
Core aggregate bonds (Agg) yield 1.53%,12 compared to two-year inflationary expectations of 2.56% 13– indicating a potentially negative real return from the coupon alone. Based on these dynamics, as well as those discussed earlier, there is one bond sector that may be able to increase yield as well as growth sensitivity: Senior Loans – one of the two segments with a positive return in 2021.
The case of senior loans can be made in three points:
For a credit allocation, loans have a relatively similar yield to fixed rate high yield debt at 3.7% versus 4.2%,14 but are more senior in the capital structure and have witnessed lower relative levels of volatility historically (5.8% versus 7.7% 60-month standard deviation of returns)15
Even with less volatility, loans, like other credit exposures, may also continue to benefit from the ongoing loose monetary and fiscal policies that have supported risk assets over the past few months during the reflation rally., Loans have outperformed the broader Agg for eleven consecutive months16
As loans have a floating rate component to them, a rise in rates may not have as much of an adverse impact on total return as it could on fixed rate high yield17– evidenced by curve change effects subtracting 142 basis points of return in 2021 for fixed rate high yield versus a negligible impact on loans18
Overall, the path ahead for rates over the next few months is likely going to be the same path birds take – migrating north as the weather turns warmer. And as the recovery forges on, the impact from rising rates on the standard sixty-forty allocation may upend what has worked over the past decade (growth stocks and long duration bonds). Investors’ ability to focus on rate sensitive stocks and growth sensitive bonds may, however, help mitigate the impact from this new higher rate and reflationary regime shift.
1 Bloomberg Finance L.P. as of February 28, 2021 based on the returns of a portfolio comprised of 60% of the MSCI ACWI Index and 40% of the Bloomberg Barclays US Aggregate Bond Index, rebalanced annually. 2 “Fed to Keep Buying Bonds Even As Outlook Improves”, Bloomberg February 23, 2021 3 “Reading Between the Lines: A Conversation With Janet Yellen”, New York Times, February 23, 2021 4 “Treasury Yields Just Spiked After a Brutal 7-Year Auction. What Investors Should Know”, Barron’s February 25, 2021 5 “House Passes Biden Aid with $1,400 Checks”, Bloomberg February 27, 2021 6 “J&J’s One-Shot Covid Vaccine Receives FDA Advisers Backing”, February 26, 2021 US Treasury Curve (10- and 2-Year Spreads) and Term Premium 7 “Risk-Parity Quants Hammered By Stocks and Bonds Moving Together”, February 26, 2021 8 Bloomberg Finance L.P. as of February 26, 2021 for the monthly returns from 2/2016 – 2/2021 for the Bloomberg Barclays US MBS Index, the Bloomberg US Treasury Index versus the Bloomberg Barclays US Aggregate Bond Index 9 Bloomberg Finance L.P. as of March 3, 2021 10 “There's a race to pass the stimulus by March 14. Here's what's at stake”, CNN March 1, 2021 11 “U.S. Insight: The Hidden Stimulus Priming a GDP Rebound”, Bloomberg March 2, 2021 12 Bloomberg Finance L.P. as of February 26, 2021 based on the yield to worst of the Bloomberg Barclays US Aggregate Bond Index 13 Bloomberg Finance L.P. as of February 26, 2021 based on the US 2 Year Breakeven rate 14 Bloomberg Finance L.P. as of February 26, 2021 based on the yield-to-worst for the S&P/LSTA Leverage Loan 100 Index and the Bloomberg Barclays US Corporate High Yield Bond Index 15 Bloomberg Finance L.P. as of February 26, 2021 based on the returns for the S&P/LSTA Leverage Loan Index and the Bloomberg Barclays US Corporate High Yield Bond Index over the prior 60-months 16 Bloomberg Finance L.P. as of February 26, 2021 based on the returns for the S&P/LSTA Leverage Loan Index and the Bloomberg Barclays US Aggregate Bond Index
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