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Written by: Scott DiMaggio and Gershon Distenfeld
Bond investors are worried, and who can blame them? From rising consumer prices to taper tantrums to climate change, there’s a pressing concern around every corner. Below, we share our risk assessments, as well as some risk-mitigation strategies. Plus, one bonus worry: bond manager technology (if you’re not worrying about this, you should be).
Worry #1: Inflation
The US is the center of concern around rising inflation, thanks to massive fiscal stimulus supporting a rapid recovery. US inflation continued to soar in May, with the Core Consumer Price Index (CPI) up 0.7% month over month and 3.8% year over year—its highest annual rate in more than 25 years.
We believe this jump in inflation is transitory. We expect price increases to decelerate as the year progresses and as pandemic-induced supply constraints ease, allowing supply to catch up to demand and taking the pressure off prices.
Could inflation become a worry in the euro area? Not anytime soon. The European Central Bank recently put its 2023 inflation forecast at just 1.7%, highlighting how far it is from achieving its inflation goals (and indicating that ongoing asset purchases will be needed long after the Pandemic Emergency Purchase Programme has expired).
While we don’t think inflation will become the major concern it was 50 years ago, investors are wise to make some adjustments to their portfolios. Even moderately higher inflation erodes the real value of investment returns and often leads to higher interest rates. In today’s inflationary climate, investors might consider these strategies:
- Modestly reduce the portfolio’s duration, or sensitivity to interest rates. Prices on shorter-term bonds fall less than those on longer-term bonds as market yields rise. Shorter bonds can also be reinvested sooner in higher yields.
- Tilt the allocation toward credit to capture incremental yields and income. That includes increasing exposure to high-yield corporates.
- Diversify across higher-yielding sectors, such as US credit risk–transfer securities (CRTs), with low correlations to government bonds and to each other. CRTs are floating-rate bonds backed by real assets—homes—that often benefit from inflation. Thanks to a robust US housing market, fundamentals look attractive for CRTs. Select emerging markets also look attractive and provide a diverse source of potential return.
Worry #2: Tapering, Tantruming and Rising Yields
While inflation has the potential to drive yields higher, so too does the unwinding of easy monetary policy. Once again, fears around rising rates center on the rapidly recovering US economy, which will soon require tapering of purchases in the US Federal Reserve’s quantitative easing (QE) program.
However, we don’t foresee a “taper tantrum” on the horizon. The Fed has learned from its mistake in 2013, when it surprised the markets with a change in monetary policy, triggering a dramatic spike in yields. This time, the central bank is laying the groundwork well in advance to avoid surprises.
Tapering, which will likely begin late this year, will be the first step on a long path toward normalization of monetary policy. The Fed will probably slow the pace of its asset purchases gradually and still be buying bonds well into 2022. Once QE purchases stop entirely, the Fed will continue reinvesting coupons and maturing bonds, making it a major player in bond markets for years to come. Once it reaches this steady state, we expect the Fed to keep the policy rate at zero for several months before eventually embarking on rate hikes.
The result over the next year or two should be a gradual rise in US bond yields, with 10-year Treasury yields climbing modestly higher by year-end 2022. Meanwhile, yields in the euro area and Japan should remain near zero, while yields in China, which has bucked the extreme-yield trend, should remain stable and comparatively high at 3.25%.
Unfortunately, these conditions leave investors between a rock and a hard place. On the one hand, bottom-scraping yields threaten to scuttle a portfolio’s return potential. On the other hand, the path to higher yields, though helpful in the long run, can be painful as bond prices initially decline. What’s an investor to do?
In our view, the strategies we already noted—shorten duration, tilt toward credit and diversify—are a solid start. But in today’s climate, investors can do more. Among the most effective active strategies are those that combine government bonds and other interest-rate-sensitive assets with growth-oriented credit assets in a single, dynamically managed portfolio.
This approach can help managers get a handle on the interplay between rate and credit risks and make better decisions about which way to lean at a given moment. The ability to rebalance negatively correlated assets helps generate income and potential return while limiting the scope of drawdowns when risk assets sell off.
Worry #3: Climate and Other ESG Risks
Climate and other environmental, social and governance (ESG) risks have also begun to emerge as a top investor concern. Investors who are eager to buy bonds that will help create a better, more sustainable world can start by learning the pros and cons of the various ESG-linked bond structures. But mitigating ESG risks doesn’t stop with buying green bonds.
To fully capture and manage the risks—and opportunities—created by ESG, managers must thoroughly incorporate ESG factors into bond analyses and investment processes. Even investors who don’t prioritize ESG stand to benefit from the integration of ESG factors into the investment process. From catastrophic environmental events to more favorable financing terms, ESG impacts every bond issuer’s bottom line.
Lastly, it’s hard to manage what you can’t measure. That’s why we’ve developed a robust method for measuring your bond portfolio’s carbon footprint.
Bonus Worry: Bond Manager Technology
Manager tech isn’t top of mind among investors, but it should be. Advanced technology can help bond managers scan the entirety of the bond market in real time, suggest potential trades, build out trades in seconds and invest new portfolios more quickly.
Three years ago, it took an average of 35 days to get a new credit or emerging-market debt portfolio 90% invested. Today, that can be accomplished in half the time—if bond managers have mastered the tech revolution. And every extra day those assets are invested amounts to more interest earned.
Lastly, cutting-edge tech allows traders to cut through the noise of thousands of bonds trading at any given time to find opportunities and source liquidity. In contrast, bond managers who don’t have the right tech will fall rapidly behind in the post-pandemic world.
Preparing for the Post-Pandemic World
The post-pandemic landscape will bring many changes. But don’t let fear send you to the sidelines. With some prudent adjustments, investors can prepare for inflation, rising rates and climate change, and position their portfolios to prosper in the post-pandemic world.
Related: Hedging Bond Bets Could Be Superior to Other Fixed Income Ideas