In a Vexing Fixed Income Market, Don't Rush to Eliminate Bonds

With Treasury yields soaring, punishing other corners of the fixed income market in the process, advisors have their work cut out for them. Clients may be getting skittish about bond allocations, and the previously trusted 60/40 portfolio mix may not be as valuable as it once was.

In other words, it’s easy to see why clients may want to ditch bonds altogether, but it’s crucial for advisors to remind them about the diversification benefits offered by these fixed income products.

“Vanguard research found that when stocks worldwide sank an average of roughly 34% during the global financial crisis, the market for investment-grade bonds returned more than 8%,” says Vanguard’s Roger Aliaga-Diaz. “Similarly, from January through March 2020—the period encompassing the height of volatility in equities due to the COVID-19 pandemic—bonds worldwide returned just over 1% while equities fell by almost 16%. And if we look at the markets over several full business cycles, from January 1988 through November 2020, whenever monthly equity returns were down, monthly bond returns remained positive about 71% of the time.”

See also: Top 69 High Yield Bonds ETFs

Those data points confirm the diversification benefits of fixed income exposure. And with yields on money markets and cash instruments so low, investors are unlikely to be rewarded when eliminating rate risk in favor of cash.

“The market consensus is that rates will rise, and the prices of short-, intermediate-, and long-term issues already reflect that belief,” notes Aliaga-Diaz. “Today’s market prices for longer-term bonds already factor in investors’ expectations for rising rates, which is why prices are cheaper. If that consensus view were to play out, there would be no advantage in shifting to shorter-term bonds or going to cash. Such moves would pay off only if longer-term yields were to rise more than expected. However, it’s equally likely that yields will rise less than expected, in which case long-term bonds would do better.”

While leaving bonds is on many investors’ minds, a different approach – considering active management – could be also warranted.

“A rising rate environment also accentuates what skilled active managers may be able to bring to a bond portfolio. When yields are falling, outperforming fund managers pile their excess returns on top of the market’s generally rising prices. But amid the headwinds of rising rates and prevailing price declines, successful active fund managers may make the difference between positive and negative total returns,” adds Aliaga-Diaz.

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