Prepare your bond portfolios for 2022 and beyond

Market challenge

There’s a lot happening in the bond market right now. Inflation has hit a 40-year high¹, pushing real yields to record low levels. Surging inflation not only means a decrease in purchasing power, but it also led to the first Fed rate hike since the end of 2018. This doesn’t mean you should run away from bonds, but rather investors need to be thoughtful when crafting their fixed income portfolios, balancing risks and rewards.

Blending active and index solutions

Step 1: start with the BlackRock Bond Pyramid

Bonds can be used for three primary purposes - income, capital preservation or equity diversification, but no bond fund can provide all three. One common mistake many aggressive equity investors make is buying speculative bonds, which can offer the potential for generous income, but also add more risk to an already stock-heavy portfolio. As your overall portfolio allocation gets more aggressive, the bonds within it may actually need to be more conservative to provide a hedge against risk. We call this “The Bond Paradox.” When building your bond portfolio, it’s important to consider what role each of your bond funds play, and then optimize your bond mix based on your larger asset allocation. That’s where the BlackRock Bond Pyramid comes in. An aggressive equity investor needs their limited bond allocation to diversify stocks. That means they should consider owning conservative bonds with high credit quality ratings and longer duration. On the other hand, a conservative investor who has less stock risk may want to dip more into credit and higher income bond funds for potentially higher yield.

Step 2: barbell each rung of your pyramid

Once you understand the role each of your bond funds play in your overall portfolio, you can then customize the rungs of your pyramid. We advocate for using a barbell approach. The left side of the barbell is about keeping fees low and transparency high with bond ETFs. With real yields at negative levels, expenses matter more than ever as high fees can eat up a big chunk of your income. Utilizing ETFs for low-cost exposures allows you to allocate the remainder of your fee budget to your right set of weights, where you’ll seek excess returns with flexible and alternative active strategies. Beware of the traditional bond mutual funds in the middle that demand a high fee for benchmark-hugging active exposures.

See it in action

Let’s say your primary goal for your bond portfolio is to offer a hedge against inflation. You may want to consider a low-cost ETF, like iShares TIPS Bond ETF (TIPS) to express inflation views and with an intermediate duration for equity diversification. You can then look to your active manager for an unconstrained fund, like BlackRock Strategic Income Opportunities Fund (BSIIX) that can help seek stability in a rising rate environment by managing duration.

What’s the bottom line?

Bond ETFs can be used as a core component to any portfolio. They seek to provide competitive performance and are an efficient way for investors to lower costs and add liquidity. At the same time, actively managed unconstrained funds can introduce new potential sources of return by providing exposures you can’t get from an index fund. When crafting bond portfolios for today’s market environment, investors can optimize their fixed income allocation for fees and yield by pairing flexible funds alongside bond ETFs.