Today’s complex environment has clients concerned with many variables that could alter the market’s trajectory: Policy normalization, tapering, low rates, fiscal spending impacts, inflationary pressures, expensive valuations, earnings growth stability, market gains concentrated around a few large stocks and the future path of an economy still dealing with the effects of the lingering COVID-19 pandemic. However, when grouped together, the through line of our client conversations centers on these two questions:
In this second part of this two-part blog, I will address the second question related to bond portfolio positioning. Check out the first part on equities here.
The Key for Bonds: Get Real for Income
On the bond side of the portfolio, investors must navigate a potentially low return environment for core bonds, given the low starting point on yields and the potential upward bias in interest rates. Sidestepping bonds all together is problematic, however. Their potential diversification benefits could be important to risk mitigation if the rosy outlook above turns out to be more sanguine.
Yet, the issues on the return side are real. Currently, 88% of all investment-grade bonds trade below the market’s expectation for inflation over the next 10 years (10-year breakeven rates are 2.4%), leading to potentially a negative real income level for the largest part of the bond market.1 As shown below, there are very few exceptions in the bond market that can generate a real income level after accounting for inflation expectations.
Bond Yields Adjusted for Inflation Expectations
As a result, generating a real level of income from bonds requires taking on some form of risk: duration, currency, or credit. So far in 2021, broad high yield credit has been the most rewarded from a return perspective, as fixed-rate below-investment-grade bonds have outperformed long-duration aggregate bonds and emerging market local debt by 7.32 and 8.91 percentage points, respectively.2
After all, credit has benefitted from some of the same forces that have propelled equity markets. And rating trends also support this level of positivity. As shown below, the ratio of upgrades-to-downgrades are at the highest level ever. Meanwhile, the upward move in rates on the year has been a headwind for long-duration bonds and the stronger dollar has sapped some of EM local debt’s strength — alongside the revised lower growth prospects for the region due to the Delta variant. For both segments, those headwinds are likely to persist and could continue to restrict total returns.
High Yield Rating Actions
For credit, however, the strong returns this year have pushed credit spreads to 47% below their 20-year long-term average,3 unfortunately creating an asymmetric return profile that indicates the potential for more downside than upside. Yet, even if returns are likely to come more from the yield (now 3.77%) — as they have historically4 — given the other options within bonds to generate a real source of income generation, this might not be a bad thing. And this asymmetry is not unique to credit markets.
With a significant amount of long-dated issuance coming to market (both corporate and Treasury), duration profiles for investment-grade bonds have become extended. For instance, the duration on the Bloomberg US Aggregate Bond Index (Agg) has increased from 6 years before the pandemic to 6.7 now. As a result, the yield-per-unit-of-duration profile of the broad Bloomberg US Aggregate Bond Index is at 0.21 — a level 33% below that of the prior three-year average. As shown below, the ratios for credit segments are much better, particularly for the floating-rate senior loan sector. And in my view, as there is upward bias on rates, taking on any extended duration risks to obtain a diminutive yield is not a valuable tradeoff in this market — from either an income or total return perspective.
Bond Market Yield Versus Duration
As a result, with the backdrop likely to remain conducive for risk-taking, an overweight to credit (either fixed-rate high yield, floating-rate senior loans, or hybrid exposures like preferred stocks) may be warranted for those in search of a real yield and potential positive total returns. And as shown in the earlier two charts, all three segments check the boxes for:
Yet, adding pure credit layers on some implicit equity risk into portfolios, and that must be appreciated from a risk perspective. As a result, barbelling credit with Treasury Inflation-Protected Securities (TIPS) could potentially add another real income stream, this time from the defensive side of the bond portfolio, to counteract some of the equity risk added from the overweight to credit.
So far in 2021, owning TIPS instead of nominals has been a beneficial swap, as TIPS have outperformed nominals by 5.7%.5 They have also outperformed the Agg by 4.8% even though they have a longer duration (8.4 years versus 6.97).6 And given the prospects for inflationary forces to remain high (still-accommodative policies even with a taper, plus increased fiscal spending), a TIPS allocation may continue to be rewarded. And as a TIPS ETF pays out all earned income in the portfolio, including the inflation adjustment that is applied to the fund's underlying securities (unlike investing in individual TIPS), a TIPS ETF may be a better source of current real income than owning TIPS outright.
Navigating Bonds in the Fourth
While the fourth quarter has historically brought increased levels of volatility — evidenced by all three months’ average CBOE VIX Index readings being at or above 20 since 1994,7 unlike any other quarter — there is an upward bias to the current market’s trajectory given supportive policies, slowing but still positive growth expectations and plenty of cash still on the sidelines.8 This should continue to provide tailwinds to equity-sensitive credit markets as the cyclical recovery continues.
However, these factors also will likely continue to spark inflationary pressures, leading to higher (but historically still low) rates. Overall, focusing on the exposures mentioned here (credit and TIPS) may allow you to navigate some of these challenges facing the bond market right now.
For implementation ideas, consider:
You can read the first part of this series here, where I review equity positioning and a key question for investors, How can I continue participating in a policy-supported rally marked by elevated valuations given concerns about the sustainability of future growth?
1. Bloomberg Finance, L.P. as of September 8, 2021 based on the yields on holdings of the Bloomberg US Aggregate Bond Index less than US 10 Year Breakeven Rate
2. Bloomberg Finance, L.P. as of September 8, 2021 based on the return of the Bloomberg EM Local Currency Govt Diversified Index, the Bloomberg US Corporate High Yield Index, and the Bloomberg US Universal 10+ Year Index
3. Bloomberg Finance, L.P. as of September 8, 2021 based on the Bloomberg US Corporate High Yield Index
4. Bloomberg Finance, L.P. as of September 8, 2021 based on the Bloomberg US Corporate High Yield Index returns from September 2011 to September 2021. The coupon has contributed to 100% of the 6.667% annualized return over the last decade.
5. Bloomberg Finance, L.P. as of September 8, 2021 based on the Bloomberg US Treasury Index and the Bloomberg US Govt Inflation-Linked All Maturities Index
6. Bloomberg Finance, L.P. as of September 8, 2021 based on the Bloomberg US Agg Index and the Bloomberg US Govt Inflation-Linked All Maturities Index
7. Bloomberg Finance, L.P. as of September 8, 2021
8. Mutual Fund Money Market Assets are in the 95th percentile, historically per Bloomberg Finance, L.P. as of September 8, 2021
Bloomberg Barclays US Aggregate Bond Index
A broad-based flagship benchmark that measures the investment grade, US-dollar-denominated, fixed-rate taxable bond market.
The difference in yield between inflation-protected and nominal debt of the same maturity. If the breakeven rate is negative it suggests traders are betting the economy may face deflation in the near future.
CBOE VIX Index
The VIX Index is a financial benchmark designed to be an up-to-the-minute market estimate of the expected volatility of the S&P 500® Index, and is calculated by using the midpoint of real-time S&P 500 Index (SPX) option bid/ask quotes.
The views expressed in this material are the views of the SPDR Research and Strategy team and are subject to change based on market and other conditions. It should not be considered a solicitation to buy or an offer to sell any security. It does not take into account any investor’s particular investment objectives, strategies, tax status or investment horizon. There is no representation or warranty as to the current accuracy of such information, nor liability for decisions based on such information. Past performance is no guarantee of future results.
This communication is not intended to be an investment recommendation or investment advice and should not be relied upon as such.
Unless otherwise noted, all data and statistical information were obtained from Bloomberg LP and SSGA as of September 8, 2021. Data in tables have been rounded to whole numbers, except for percentages, which have been rounded to the nearest tenth of a percent.
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Prior to 02/26/2021, the SPDR Blackstone Senior Loan ETF was known as the SPDR Blackstone / GSO Senior Loan ETF.
Prior to 05/01/2021, the SPDR ICE Preferred Securities ETF was called SPDR Wells Fargo Preferred Stock ETF.
Bonds generally present less short-term risk and volatility than stocks, but contain interest rate risk (as interest rates raise, bond prices usually fall); issuer default risk; issuer credit risk; liquidity risk; and inflation risk. These effects are usually pronounced for longer-term securities. Any fixed income security sold or redeemed prior to maturity may be subject to a substantial gain or loss.
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