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Down 1% year-to-date, the widely observed Bloomberg US Aggregate Bond Index is confirming what many advisors already know: 2021 is proving to be a tricky, borderline treacherous year on the fixed income front.
When it comes to clients' bond allocations, advisors are contending with numerous headwinds this year. Let's start with inflation. Though it's forecast to ebb over the next several years, it's punitive this year and if economics' projections are accurate, rising prices will remain above the Federal Reserve's desired 2% target for several years to come.
Speaking of the Fed, the central bank isn't making life easy on advisors with talk of tapering and rate hike timeline that's dramatically accelerated from the start of the year. It's now increasingly likely the Fed will raise interest rates next year. At the start of 2021, expectations were in place that the next rate hike would arrive in 2023 or even as late as 2024.
Compounding the fixed income conundrum for advisors is that Treasury and municipal bond yields are low and credit spreads are depressed. Add all of these factors up and it's reasonable to expect that advisors are pondering what to do about bond allocations in the fourth quarter and heading into 2022.
Points to Consider
When it comes to bonds today, astute clients are likely making demands, rightfully so, on two fronts. First, there's a clear need for real income. Second, smart clients probably don't want to throw in the towel entirely on bonds and as such, they'll want exposure to policy-supported fixed income segments.
Of course, advisors still face myriad challenges, namely identifying corners of the bond market that will top inflation – something that's getting harder to do these days.
“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,” says Matthew Bartolini, head of SPDR Americas Research. “There are very few exceptions in the bond market that can generate a real income level after accounting for inflation expectations.”
Translation: To be profitable in bonds and beat inflation, some form of risk acceptance is required, be it credit, currency or duration risk. Problem is, as noted above, credit spreads are low, meaning the risk may not be worth the reward as things stand today.
“For credit, however, the strong returns this year have pushed credit spreads to 47% below their 20-year long-term average, unfortunately creating an asymmetric return profile that indicates the potential for more downside than upside,” adds Bartolini.
No Need to Go Risk-Crazy in Q4
While it sounds ominous that credit spreads aren't appealing and that inflation could prove more persistent than originally hoped, those scenarios don't mean advisors need to expose clients to excessive fixed income risk.
In preparing to close out 2021, some basics such as bank loans, preferred stocks and Treasury Inflation-Protected Securities (TIPS) – each of which are already performing admirably this year – could continue serving investors well.
“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, 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,” notes Bartolini. “This should continue to provide tailwinds to equity-sensitive credit markets as the cyclical recovery continues.”
An emphasis on credit and TIPS could serve clients well to finish off 2021 and into 2022 as well.
Related: Bank Loans for the Win as Rates Rise