THE BONDS OF LIBERATION

The Bonds of Liberation

Trump’s slew of “Liberation Day” tariffs delivered a shock to markets, introducing yet another bout of volatility in a year that has been marked by a volatile start just three months in. Amidst heightened growth and inflation concerns, we explain what this means for the opportunity in fixed income, and the bond ETFs that can deliver the precision for investors to position themselves for the impact of tariffs.

Bonds as ballast

Amidst the broad selloff in equities in response to the tariff announcements, correlation has moved back into negative territory, with duration assets seeing a rally. Fixed income has historically been an effective portfolio ballast especially during risk-off periods, increasing the appeal of core fixed income allocation for equity diversification again (Figure 1).

What happens from here?

While the market consensus is that tariffs will drive inflation higher and growth lower, uncertainty over the path of tariffs going forward means that investors have one key question to consider - how will inflation-growth dynamics play out?

Scenario 1: Recession fears overshadow inflation

Where growth concerns take the front seat and rates are expected to fall while credit spreads widen, investors increase portfolio ballast with rates while extending duration within portfolios.

With granular maturity buckets available in the US Treasury ETF toolkit, investors can access duration through the 3-7 year belly of the curve.

Alternatively, a barbell approach could offer a more attractive yield/duration profile while reducing portfolio risk. Short-end US Treasuries offer stability and income, while the long-end serves as a capital efficient option to add duration to portfolios with maximum price appreciation potential.

Scenario 2: Inflation spikes triggering rates reversal

If inflation rears its ugly head, the Fed will likely lack the room to cut rates, meaning rates could remain steady or even continue to rise. TIPS, specifically short duration TIPS, offer a balance in managing inflation risk and interest rate risk.

At a yield level of over 3.6% today which comprises majority breakeven inflation (2.5%) and the rest real yield (1.1%), investors can benefit from an inflation hedge should inflation rise, while maintaining a nominal duration sensitivity of only just over 2 years.

Short duration TIPS have seen stronger inflows in a year which has seen flows broadly returning to TIPS ETFs.

No Time to Yield

A case for putting cash to work with bond ETFs

Last year, our whitepaper “The Great Yield Reset” discussed the generational opportunity for investors to rethink their portfolios with a greater focus on fixed income.

In our latest paper “No Time To Yield”, we highlight our updated expectation that global bond ETFs will reach US$6 trillion in AUM by 2030. We discuss the opportunity within bonds and why investors may want to consider moving now to capture decades high yields, get cash off the sidelines, and employ efficient, precise tools such as bond ETFs in this new market regime.

As investors take a more dynamic approach to asset allocation, we believe bond ETFs are among the most powerful tools within the investor tool kit to navigate this market environment.

The timing of potential interest rate cuts may be uneven worldwide, but the message is clear: Don’t wait.

Source: BlackRock, “No Time to Yield”, as of April 2024. There is no guarantee that any forecasts made will come to pass.

Key themes we discuss in this piece:

1. Time to put cash to work and capture higher rates Yields are higher today than they have been in years. If inflation indicators continue to fall, the time of elevated cash rates may be drawing to a close.
2. Investors are choosing bond ETFs in record numbers, but they have room to do more Many investors are still significantly underweight to fixed income, with a 22% average allocation, based on total global industry AUM, far below the “60/40” portfolio allocation often referenced in balanced portfolio discussions.
3. Now is the time to move Even with ongoing volatility in economic data and bond markets, we believe it’s time for investors to move because, historically, the market has tended to price in rate actions before they occur.

Index Your Bonds with Asia Credit

Asia bond markets definitely have a part to play in the next leg of growth in index and ETF adoption. As investors continue to move beyond the “active versus passive” debate, constant product innovation will offer increasingly precise sources of potential returns, and help lead more investors to embrace bond index building blocks alongside high conviction active strategies in pursuit of optimal portfolio outcomes.

In this Asia-focused “Index Your Bonds” paper, we spotlight iShares Asia Credit exposures, provide insights on how they are managed in practice, and discuss how innovations such as ESG integration will make indexing an integral part of investing in Asia fixed income.