Bond market and currency volatility have been on the rise lately, leaving many investors wondering what they should do in response.
My take: I’ve been advocating for a while that investors should rethink their fixed income exposure, given that bond investing today is very different than it was in the past.
It’s never accurate to describe investing — whether asset allocation or beating a benchmark — as “easy.” That said, it’s fair to say bond investing used to be “easier.”
For more than three decades, bond managers had the enviable advantage of consistent tailwinds: falling inflation and declining real rates. While bond markets would still suffer the occasional gyration, those dislocations occurred against the backdrop of a multi-decade bull market and steadily declining volatility.
Some of those conditions, notably low inflation, remain in place, but the overall environment is less hospitable than it was a decade ago. Today, bond investors face several significant challenges, all of which are likely to impact both the expected return, as well as the riskiness, of bond funds:
Historically low rates, both nominal and real. Traditional bond market aggregates are overwhelmingly weighted toward U.S. government bonds. While Treasury yields are up roughly 100 basis points (bps) from their all-time lows, both nominal and real yields are still a fraction of their long-term average. For example, 10-year Treasury real yields are roughly 50 bps, versus their long-term average of five times that level.
Even before accounting for taxes, investors are receiving little return after inflation, unless you believe that inflation will fall even further from already soft levels. Compounding the problem, yields are even lower in other developed countries. Comparable yields on German bonds are roughly 1% and in Japan, comparable yields are 0.5%.
What’s driving the low yield environment? While extraordinary monetary policy has played its part, today’s low yields are largely a reflection of low nominal growth throughout the developed world. To the extent that demographic and other long-term factors are responsible, this phenomenon is likely to continue in the years ahead, and rates are likely to remain relatively low by historical standards.
Tight spreads. Low yields in the sovereign bond market have pushed more and more investors into other fixed income segments, including riskier instruments such as high yield and emerging market debt.
While these asset classes still offer higher yields than government bonds or investment grade corporates, a multi-year bull market in high yield means spreads are tight and yields are well below average. Even in emerging markets debt, an asset class that many investors shunned earlier this year, spreads have tightened and yields have dropped. The bottom line: Even for investors willing to take on incremental risk, the pickup in yield offered by traditionally riskier segments is less than it used to be.