As resolutions go, rethinking your fixed-income portfolio may not resonate in quite the same way as dropping 10 pounds or finally giving up that smoking habit. But if ever there was an opportunity to reassess how you approach bond investing, now is the perfect time.
Last year our lead theme of How I Stopped Worrying and Learned to Love the Bond favoring longer-maturity debt was right, even if for the wrong reasons. We thought rates would go up but long bonds would outperform; the latter was correct but the former clearly was not. This year our lead theme All About That Pace again appears out of consensus as the market view for rates has shifted towards fears of deflation and expectations that low global rates means U.S. rates can never move higher. The latter part of the year also brought plenty of financial-market volatility—a trend that is likely to continue in 2015. If persistent zero interest rates and quantitative easing that were intended to lead investors to take more risk in pursuit of higher yielding assets led to dampened volatility, we should expect greater financial market volatility in 2015 as the Fed pulls back from its zero rate policy.
It’s partly because of that volatility that fixed-income investors need to reassess their commitment to bonds. Always keep in mind what role bonds play in your portfolio:
- Diversification: Use traditional bond strategies to diversify equity exposure.
- Source of Protection: Use flexible bond strategies to guard against interest rate and credit events.
- Income: Use yield-focused solutions to help generate income.
The benign environment of the past six years has bred complacency in investments expected to have the least amount of risk. This is particularly the case for bonds that, in today’s zero interest rate environment, have commonly been used as surrogates for cash. That complacency should now be challenged if the outlook that the Fed is finally going to raise rates is realized. Our shorten your duration but don’t own short duration theme captures this idea. Higher yielding strategies have been rewarded in the past, but those yields result from greater interest rate or credit/illiquidity risk, or both.
While reaching for yield has been successful in the past, we suggest increasing credit quality, increasing liquidity and reducing risk in an environment where the Fed’s policy changes introduce a very different forward-looking outlook. That different outlook is captured in the figure nearby highlighting how the downside risks to bonds—in this case looking at short duration bonds—is masked in an era of zero interest rate policy but is revealed when the Fed begins raising rates.
No Longer a Cash Alternative: Risks in Short Duration Expand During Hiking Cycles