This is an exciting time to be an investor, but it’s also a very uncertain one. Risks to both the upside and downside are much higher than they were even a year ago.
After about a decade of near-zero interest rates in the U.S., the Federal Reserve has started to raise rates as the economy strengthens. A new administration wants to increase fiscal spending and reform the tax code, both of which could propel growth higher if enacted. Yet there are downside risks: political polarization, stock markets at record highs (along with high valuations for most risk assets broadly), rising geopolitical tensions and inflation surprises, among others.
In this uncertain environment, core bonds may be able to offer some relief: the potential for stability within a broad investment portfolio and diversification relative to investors’ equity allocations.
So where are the opportunities in bonds amid the uncertainty?
Five ideas in core bonds
Overall, we think it’s important to recognize that low rates have affected all markets. Easy central bank policies have in effect pulled future returns forward by supporting valuations across asset classes. As a result, returns are likely to be lower than in the past, so alpha – above-market return – will be particularly important in meeting investors’ goals.
For that reason, we think active management is crucial. Rather than simply buying and holding the bonds in an index, active managers select the bonds in a portfolio and can therefore target opportunities for alpha, while aiming to avoid volatility. To the extent rates do grind higher as a result of the very gradual normalization envisioned by the Fed, expected returns should also be on the rise – and actively managed, diversified portfolios have the opportunity to outperform with potentially less risk (e.g., lower interest rate exposure) than passive strategies.
Here are five specific areas where we see value:
- U.S. agency mortgages. Compelling relative value opportunities along the coupon stack exist in agency mortgages, particularly as a way to add high quality and diversifying yield with minimal credit risk. With Fed balance sheet normalization on the horizon, the potential for yield spread widening remains; however, this is a risk we think is manageable, especially given the additional yield on mortgages relative to government bonds.
- Inflation hedging. Inflation pressures could gain momentum over the medium term, so we think TIPS (Treasury Inflation-Protected Securities) offer attractively priced hedges against the possibility that inflation expectations push bond yields higher (much as they did in the second half of 2016).
- Financials. As equity markets have set all-time highs over the past several months, corporate bond yield spreads versus Treasuries have tightened significantly, making corporate bonds less attractive. However, we see opportunities in select sectors, particularly financials, where balance sheets are generally healthy.
- Non-agency mortgages. Mortgages originated before the financial crisis that have been resilient through the years are now supported by improving housing fundamentals as well as a strong labor market. This combination of exposure to a solid U.S. housing sector and stabilized cash flows provides a compelling value proposition for these securities.
- U.S. Treasuries. It may seem strange to advocate U.S. government bonds when yields are at historical lows, but there is value beyond yield hunting. With valuations stretched across risk assets at a time when a key driver – monetary policy accommodation – appears to be waning, defensive portfolio construction can prove prudent. U.S. Treasuries are one of the most liquid, high quality ways to diversify and potentially provide the negative correlation to most risk assets that investors seek in core bonds.
What about the Fed raising rates? The front end of the yield curve is usually most affected by Fed rate hikes, while the intermediate portion of the curve is likely to see less of an impact. Thus, holding high quality government exposure outside the very front end (while also avoiding the less attractive long end) could prove invaluable in what may be a complacent market environment.
Read more in a Q&A with Scott Mather.