As such, I advocate shying away from nominal (unadjusted for inflation) Treasuries. Instead, I believe it’s prudent to extend allocations in other bond sectors and exposures that offer similar interest-rate sensitivity to Treasuries, but with more compelling investment cases.
U.S. Municipals: This has been the best performing bond sector over the last year, according to Bloomberg data for the Barclay’s Municipal index. Going forward, the sector should be supported by improving fundamentals and lower bond issues. In addition, yields look attractive on a relative basis with long-dated municipals yielding above comparable Treasuries.
U.S. Treasury Inflation Protected Securities (or TIPS): I prefer getting duration exposure from TIPS over Treasuries, given the still very low inflation expectations priced into the market. While I don’t see runaway inflation on the horizon, there are some signs of higher prices ahead. For instance, the tightening labor market may be starting to show long-awaited wage gains. Lastly, TIPS, like U.S. Treasuries, are U.S. government securities.
Barclays Aggregate (Agg): Since 2013, many investors have shunned this bond index, believing the Agg’s higher duration or interest rate risk left portfolios exposed to large losses if interest rates shot up. But historically, BlackRock analysis shows, including some Agg-like products can create a more optimal risk-return portfolio. In addition, while the Barclays Aggregate Index is dominated by Treasuries, it also includes agency mortgage securities as well as investment grade debt. In short, it provides a broad, diversified exposure to help balance out equity risk.
Market Realist – How to ballast your portfolio with bonds—and without Treasuries.
The graph above compares the returns on various fixed-income classes in 2015. Municipal bonds (or munis) were the best performers in 2015 with returns of 3.2%. Meanwhile, investment-grade corporate bonds (LQD), long-dated Treasuries (TLT), and high-yield bonds (HYG) all gave negative returns in 2015.
Munis (MUB) may continue to outperform in 2016 for several reasons, including limited supply, rising tax rates, and attractive yields in the current ultra-low rate environment. Remember, most municipal bonds are tax-free, which makes them attractive—especially to people in high tax brackets.
The graph above shows the year-over-year headline inflation rate based on the CPI (consumer price index). The inflation rate has picked up over the last few months. Inflation stood at 0.7% in December compared to 0.0% in September.
Inflation firmed over the last few months as the one-off impact of lower energy prices started to fade from CPI calculations, as we pointed out in December. Inflation may head even higher, though not by much.
Treasury Inflation-protected securities or TIPS (TIP) may be a worthwhile option. Inflation-protected securities are one of the few assets that directly compensate you for inflation. Also, inflation expectations are near all-time lows, which makes TIPS relatively attractive.
Read What Investors Need to Know About Returns in 2016 for more on how to position your portfolio in today’s environment.