Harnessing Uncertainty: Five Opportunities in the Core Bond Market
This is an exciting time to be an investor, but it’s also a very uncertain one. Risks to both the upside and downside are much higher than they were even a year ago.
After about a decade of near-zero interest rates in the U.S., the Federal Reserve has started to raise rates as the economy strengthens. A new administration wants to increase fiscal spending and reform the tax code, both of which could propel growth higher if enacted. Yet there are downside risks: political polarization, stock markets at record highs (along with high valuations for most risk assets broadly), rising geopolitical tensions and inflation surprises, among others.
In this uncertain environment, core bonds may be able to offer some relief: the potential for stability within a broad investment portfolio and diversification relative to investors’ equity allocations.
So where are the opportunities in bonds amid the uncertainty?
Five ideas in core bonds
Overall, we think it’s important to recognize that low rates have affected all markets. Easy central bank policies have in effect pulled future returns forward by supporting valuations across asset classes. As a result, returns are likely to be lower than in the past, so alpha – above-market return – will be particularly important in meeting investors’ goals.
For that reason, we think active management is crucial. Rather than simply buying and holding the bonds in an index, active managers select the bonds in a portfolio and can therefore target opportunities for alpha, while aiming to avoid volatility. To the extent rates do grind higher as a result of the very gradual normalization envisioned by the Fed, expected returns should also be on the rise – and actively managed, diversified portfolios have the opportunity to outperform with potentially less risk (e.g., lower interest rate exposure) than passive strategies.
Here are five specific areas where we see value:
- U.S. agency mortgages. Compelling relative value opportunities along the coupon stack exist in agency mortgages, particularly as a way to add high quality and diversifying yield with minimal credit risk. With Fed balance sheet normalization on the horizon, the potential for yield spread widening remains; however, this is a risk we think is manageable, especially given the additional yield on mortgages relative to government bonds.
- Inflation hedging. Inflation pressures could gain momentum over the medium term, so we think TIPS (Treasury Inflation-Protected Securities) offer attractively priced hedges against the possibility that inflation expectations push bond yields higher (much as they did in the second half of 2016).
- Financials. As equity markets have set all-time highs over the past several months, corporate bond yield spreads versus Treasuries have tightened significantly, making corporate bonds less attractive. However, we see opportunities in select sectors, particularly financials, where balance sheets are generally healthy.
- Non-agency mortgages. Mortgages originated before the financial crisis that have been resilient through the years are now supported by improving housing fundamentals as well as a strong labor market. This combination of exposure to a solid U.S. housing sector and stabilized cash flows provides a compelling value proposition for these securities.
- U.S. Treasuries. It may seem strange to advocate U.S. government bonds when yields are at historical lows, but there is value beyond yield hunting. With valuations stretched across risk assets at a time when a key driver – monetary policy accommodation – appears to be waning, defensive portfolio construction can prove prudent. U.S. Treasuries are one of the most liquid, high quality ways to diversify and potentially provide the negative correlation to most risk assets that investors seek in core bonds.
What about the Fed raising rates? The front end of the yield curve is usually most affected by Fed rate hikes, while the intermediate portion of the curve is likely to see less of an impact. Thus, holding high quality government exposure outside the very front end (while also avoiding the less attractive long end) could prove invaluable in what may be a complacent market environment.
Read more in a Q&A with Scott Mather.
Past performance is not a guarantee or a reliable indicator of future results. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and the current low interest rate environment increases this risk. Current reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Inflation-linked bonds [ILBs] issued by a government are fixed income securities whose principal value is periodically adjusted according to the rate of inflation; ILBs decline in value when real interest rates rise. Treasury Inflation-Protected Securities [TIPS] are ILBs issued by the U.S. government. Mortgage and asset-backed securities may be sensitive to changes in interest rates, subject to early repayment risk, and their value may fluctuate in response to the market’s perception of issuer creditworthiness; while generally supported by some form of government or private guarantee there is no assurance that private guarantors will meet their obligations. Certain U.S. government securities are backed by the full faith of the government. Obligations of U.S. government agencies and authorities are supported by varying degrees but are generally not backed by the full faith of the U.S. government. Portfolios that invest in such securities are not guaranteed and will fluctuate in value. Management risk is the risk that the investment techniques and risk analyses applied by an active manager will not produce the desired results, and that certain policies or developments may affect the investment techniques available to the manager in connection with managing the strategy
There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market. Investors should consult their investment professional prior to making an investment decision.
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