Reboot your bonds

Mar 30, 2022
  • BlackRock

Fixed income investors have been fighting an uphill battle. Bond prices fell last year as market participants anxiously awaited the start of the Fed’s rate hiking cycle. While short-term yields had largely adjusted to the new rate regime well before it began, rising rates remain a key risk along the remainder of the yield curve.

Higher inflation – a fundamental enemy of fixed income – has come on with a vengeance, reaching levels not seen in 40 years. Russia’s attack on Ukraine adds fuel to this economic fire as higher oil prices exacerbate inflation and challenge global growth.

Take advantage of higher short-term rates

The market’s acute focus on the Fed’s evolving sentiment and policy planning over the past year impacted short-term fixed income assets well in advance of the first rate hike. The front end of the yield curve has adjusted for the assumption of a more-than-ample number of additional rate hikes in 2022 and 2023 and, at long last, short-term bonds are providing meaningful yields.

Investors who are holding cash have an opportunity to put it to work on the short end of the yield curve. Providing your clients with capital preservation is especially important as higher inflation threatens to erode the purchasing power of cash.

Check your diversification

Advisors’ search for yield in 2021 resulted in less diversified bond allocations at the start of 2022. As interest rate concerns mounted over the past year, advisors trimmed positions in rate-sensitive sectors typically relied upon for portfolio ballast against equity risk, while adding to positions in more credit-sensitive sectors.

Advisors trimmed portfolio ballast
Largest year-over-year changes in advisor models

Advisor models

Source: BlackRock. Based on Morningstar category exposures in the fixed income sleeves of 16,699 advisor models of 12/31/21 and 15,864 advisor models as of 12/31/20.

Despite the increased credit exposure, the average advisor bond allocation generated less yield year-over-year as tighter credit spreads and shorter duration led to lower yields in even the most yield-heavy categories. For example, the 25-basis-point drops in bank loans (from 4.20% to 3.95%) and high yield bonds (from 5.73% to 5.48%).1

As the robust economic re-start charged onward, credit assets generally became less risky, driving down the overall risk level of advisor bond allocations. While a lower overall risk may sound comforting, the associated reduced diversification is less so.

Advisor’s bond allocations provided lower risk, but lower yields in 2021

Advisor bond allocation

Source: BlackRock, Morningstar. For illustrative purposes only. Data reflects trailing 12-month yields. 2021 data is based on the fixed income sleeves of 16,699 advisor models of 12/31/21; 2020 data is based on the fixed income sleeves of 15,864 advisor models as of 12/31/20.

Align risks with your client’s goals

Weigh today’s bond market risks in context of your client’s goals and risk tolerance. Balance the levels of risk you take relative to potential client outcomes in various scenarios.

Overreacting to any one risk could lead to unintended exposure to another. As an example, bond portfolios with the least exposure to rising interest rates have historically tended to underperform in less risky environments. Consider all of the risks relevant in the current market environment but be intentional about the tradeoffs you accept and analyze the potential impact to the whole portfolio.

Allocate relative to your risk concerns

You are in the unenviable position of having to simultaneously navigate rising rates, high inflation and higher volatility for your clients. It may be tempting to abandon the markets altogether and go into cash, except that cash automatically loses money in an inflationary environment, which further hinders your clients’ ability to hit their return targets.

So what can you do? Select the instruments that help combat the risks you and your clients are most concerned about, and weight them according to your level of concern and the likelihood of them happening.

Risk concerns

Choose your tools

As you “reboot” your clients’ bond allocations, consider what you are comfortable managing and where it makes sense to pay for active management.

When choosing actively managed open-end funds, be sure that you are getting something that couldn’t otherwise be achieved through index exposures. Only pay for performance driven by expertise in market timing, security selection or the ability to participate in markets that are difficult to access. Actively managed funds with a flexible strategy can introduce new potential sources of return while adapting to market changes.

Exchange-traded funds (ETFs), on the other hand, allow you to pull the levers. The extensive variety of bond ETFs available today allows you to get granular on sector exposure, curve positioning or duration. All of the decision-making is on you, but you can help your clients save on management fees and reduce tax costs. Much of the large increase in TIPS exposure noted above was implemented using targeted ETFs.2

Using a blend of open-end funds and ETFs allows you to outsource your clients’ core fixed income exposure while tactically expressing your own views on the market. For example, if you are more concerned about inflation than your active fund manager is, you can trim that fund holding and reallocate to an inflation fighter ETF.

The low fees associated with index ETFs allows you to balance out the higher costs of actively managed funds with strong performance track records. If your client’s time horizon allows, you also might consider seeking new sources of return by reallocating a portion of your fixed income to active alternative strategies.

Don’t power down… Reboot!

In times of uncertainty, clients need assurance that their advisor knows what to do. Show them how you help them manage risk and take opportunities in volatile markets within a well-diversified portfolio.

  • Preserve capital by taking advantage of higher yields on short-term fixed income assets.
  • Align your risk taking with your client’s goals and analyze potential outcomes.
  • Choose open-end funds that provide benefits worthy of their cost. A well-managed flexible strategy can tactically manage risks as markets change.
  • Use tax-efficient, low-cost ETFs for exposures you want to manage on your own.

BlackRock can help you manage risk in today’s bond markets. Contact your BlackRock representative or explore our investment tools, resources and more portfolio insights.