4 tips to help recharge your
bond portfolio

May 24, 2017
By BlackRock

This is not your grandfather’s bond market. The expectation that bonds are essentially “risk-free,” steady income generators may require a tune-up.

Fixed income markets have changed meaningfully. Bond yields, after declining for the past 35 years, may have finally hit bottom. In other words, their next definitive move is probably up — which means bond prices are poised to fall.

At the same time, bonds still serve three important and irrevocable roles in an investment portfolio, seeking to: preserve capital, generate income and offset equity risk.

As much as the markets may change, these reasons — and the basic need — to hold bonds does not. But your strategy for managing your fixed income allocation should most certainly evolve with the times, and that may require you to strap on the training wheels for a time to reassess the opportunities and risks.

Why do you hold bonds?

Why do you hold bonds?

Fixed income 2.0

Once upon a time, fixed income investing might have seemed fairly uncomplicated. U.S. Treasuries and other governmentand agency-related issues were the gold standard for a steady stream of income at little to no risk. At the turn of the century, the 10-year Treasury had a yield of roughly 6.5%; even a three-month T-bill boasted a yield above 5%.

Seventeen years and one major financial crisis later, the 10-year Treasury opened 2017 with a yield of 2.45% (nearly the same place it started 2009) and the three-month T-bill offered 0.53% — hardly an ample income stream, particularly for retirees relying on their investment portfolio to provide a source of liquidity and cash flow.

While not an exhaustive assessment, following are three ways fixed income investing is more challenging in the current moment:

Low for longer

Two important structural factors are likely to keep yields relatively subdued over the long term, according to Rick Rieder, Chief Investment Officer of Global Fixed Income at BlackRock.

“We are likely to see better rates of economic growth and inflation in the year ahead, but the longer-run themes and challenges of both an aging population and technological disruption will continue to be firmly in place,” he explains, noting their important role in tempering the rise in bond yields.

For its part, technological innovation and associated productivity gains may keep a lid on inflation. And an aging population (producing more retirees than workers) could mean a long-term downshift in economic growth. Older individuals also tend to borrow less and exhibit a preference for fixed income. This serves to both lower the supply and increase the demand for longer-term bonds — thereby propping up prices and continuing to hold yields down.

The upshot: Yields are likely to remain low for longer, perpetuating the challenge income seekers have faced for years. But there is a near-term counterforce that investors cannot ignore: reflation.

Reflation and rising rates

Reflation, a virtuous cycle of rising economic growth, prices and wages, is taking hold and broadening its reach globally. In the U.S., this is accompanied by a Federal Reserve in the midst of a rate-hiking cycle. All of this portends a near-term rise in bond yields — and drop in bond prices. It also sets up a tension between the long-term structural factors noted above and the short-term dynamics.

Are bonds losing their diversification benefit?
90-day correlation of stock and bond returns

Are bonds losing their diversification benefit?

 

It will be important for investors to discern between the shorter-term opportunities and risks present in markets and the structural factors that are not easily changed, yet hold profound implications for global capital markets.

— Rick Rieder, Chief Investment Officer of Global Fixed Income

Diluted diversification

Another notable change of late: A shift in stock/bond correlations.

“While bonds have not offered much in the way of income in recent years, they have provided diversification from equity risk,” says Russ Koesterich, portfolio manager of the BlackRock Global Allocation Fund. “But change may be afoot.

“Stocks and bonds have tended to be negatively correlated in recent years, but we’re seeing this trend back toward the historic norm.”

The implication: Bonds may not be quite the equity hedge they were for most of the post-financial-crisis period. Mr. Koesterich adds that, historically, stock/bond correlations have been impacted by monetary policy. “If the Fed continues to tighten, we may see further normalization in correlations."

Back to basics

As much as the fixed income opportunity set has changed, investor needs have not. And that suggests a need to get back to basics.

“Whether you’re seeking to preserve principal, generate income, diversify stocks, or any combination of the three, this should not change simply because the bond market has changed,” says Matt Tucker, Head of iShares Fixed Income Strategy for the Americas region.

But investors should be aware it can be difficult for their bonds to achieve any one of those goals, let alone all three at once.

“In 2006, the federal funds target rate stood at 5.25% and a three-month Treasury bill yielded 5%. That’s decent income and low volatility,” Mr. Tucker suggests, adding that today’s market does not offer the same opportunities:

“While Treasuries provide some of the best diversification against equities, they are not providing a lot of income. Now, investors might achieve an incremental income boost in high yield investments, but they would sacrifice some portfolio diversification in the process since high yield markets are more closely correlated to equities. This also implies higher volatility.”

Mr. Tucker advises being precise with what you want your fixed income investments to do. Hold realistic expectations, and stick with your goal. Of equal importance, don’t abandon bonds.

“Investors are too often tempted to sell if their investments are falling in price.” Mr. Tucker notes that acting on emotion is rarely fruitful, and points out that rising interest rates may actually be good for long-term investors in bond funds.

“When interest rates rise, the price of your bond fund will drop — at first. But then the fund begins to reinvest cash flows at the new higher yields, steadily boosting income. Over time, this increased income can potentially offset the initial price decline,” Mr. Tucker explains, adding that continued reinvestment at higher yield levels has the potential to generate higher returns.

 

Fixed income goalMarket challengeTo do’s to consider
Preserve capital Rising rates causing a drop in bond values in the short term Consider flexible fixed income strategies that tactically manage around rate risk. Floating rate securities may offer some downside protection as well.
Generate income Structural dynamics making for a low-for-longer rate environment Consider multi-asset income strategies that are not limited by asset class or geography in their search for income opportunities
Offset equity risk Tighter stock / bond correlations challenge traditional diversification benefits Maintain some exposure to the highest-quality fixed income investments, such as Treasuries and municipal bonds, as the more potent offsets to equity risk.

Tips to tune up your portfolio

Investing with a long-term mindset is important. It’s also prudent to tactically adjust for the prevailing environment. Following are strategies to help you navigate today’s more dynamic, less certain fixed income environment:

1. Blend your bonds

No one bond strategy can do it all today. High-quality, long-dated bonds offer an important ballast to stock market risk in a broadly diversified portfolio. Flexible fixed income strategies, meanwhile, are particularly adept at managing around interest rate risk. Pairing the two may help reduce interest rate risk, improve diversification and enhance your portfolio’s total return potential.

2. Float your interest rate

Floating rate securities make intuitive sense when bond yields rise. Their coupons reset to prevailing rates, allowing them to potentially skirt some of the price declines that impair fixed-rate bonds. Because the asset class has gotten somewhat pricey as investors acknowledge this fact, it may be prudent to tilt toward more conservative floating rate strategies.

3. Look beyond bonds …

For income seekers, multi-asset strategies have shown themselves to be dependable performers when bond yields have risen, combining a range of less interest-ratesensitive asset classes while still pursuing a consistent income stream. Dividend stocks can also be a useful source of income, with one caveat: High-dividend stocks may trade more like fixed income if yields were to surge. While dividend payments are never a guarantee, dividend-growth stocks appear to offer an advantage over the high-yielding bond proxies in the current environment.

4. … and outside the U.S.

Investors are wise to maintain flexibility in their investment portfolio, and that includes greater use of global bond market opportunities. Expanding outside the U.S. increases the investable universe by 2.67 times, from $36 trillion to $96 trillion, and can uncover opportunity in a host of other currency, rate, yield curve and credit tools.

For more on the current risks and opportunities in fixed income investing, visit blackrock.com/fixedincome.

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