Survey the Longer-Term Landscape
While taking a step back from day-to-day variability in data helps us get a better view of the medium term, it also helps us survey the longer-term landscape. And that landscape is changing.
For the past 40 years, global deflationary forces have prevailed, facilitating a regime of low equilibrium inflation. But mounting pressures from three powerful macro megaforces—deglobalization, demographics and climate change—point toward higher structural inflation and increased inflation volatility in the coming decade.
Indeed, over the next 10 years, we think it’s more likely that 2% becomes a lower bound for inflation, rather than a central-bank target. It’s highly likely we’ve already entered this new regime, though evidence of it has been masked by recent disinflation from cyclical highs.
Higher inflation implies higher nominal yields, and higher inflation volatility implies steeper yield curves. Over the past decade, term premiums have mostly evaporated. In the next decade, we think term premiums will increase to compensate investors for the risk of holding longer-maturity bonds in an environment of less-certain inflation expectations.
After more than two decades of exceptionally low rates and under-allocations to fixed income, a new regime of higher equilibrium inflation, higher nominal yields and higher volatility could reshape how investors allocate capital over the long run, with allocations to active fixed income and inflation strategies playing a bigger role than in recent years.
Strategize for Today’s Environment
In our view, bond investors can thrive in today’s favorable environment by applying these strategies:
1. Get invested. As noted above, yields have generally declined in the months before the first central bank rate action. That’s why those who are invested in bonds are well positioned for potential returns.
2. Extend duration. If your portfolio’s duration, or sensitivity to interest rates, has veered toward the ultrashort end, consider lengthening your portfolio’s duration. As the economy slows and interest rates decline, duration tends to benefit portfolios. Government bonds, the purest source of duration, also provide ample liquidity and help to offset equity market volatility.
3. Hold credit. Though spreads are on the tighter side, yields across credit-sensitive assets such as corporate bonds and securitized debt are higher than they’ve been in years, giving income-oriented investors a long-awaited opportunity to fill their tanks. Because corporate fundamentals started from a position of historic strength, we’re not expecting a tsunami of corporate defaults and downgrades. Plus, falling rates later in the year should help relieve refinancing pressure on corporate issuers.
But credit investors should be selective and pay attention to liquidity. CCC-rated corporates and lower-rated securitized debt are most vulnerable in an economic slowdown. Long-maturity investment-grade corporates can also be volatile and are currently overpriced, in our view. Conversely, short-duration high-yield debt offers higher yields and lower default risk than longer debt, thanks to an inverted yield curve.
4. Adopt a balanced stance. We believe that both government bonds and credit sectors have a role to play in portfolios today. Among the most effective strategies are those that pair government bonds and other interest-rate-sensitive assets with growth-oriented credit assets in a single, dynamically managed portfolio. This kind of pairing also helps mitigate risks outside our base-case scenario of weak growth—such as the return of extreme inflation, or an economic collapse.
5. Protect against inflation. Given the heightened risk of future surges in inflation, the corrosive effect of inflation and the affordability of explicit inflation protection, investors may want to consider increasing their allocations to inflation strategies.
6. Consider a systematic approach. Today’s environment of weakening economic growth also increases potential alpha from fixed-income security selection. Active systematic fixed-income investing approaches, which are highly customizable, can help investors harvest these opportunities.
Systematic approaches rely on a range of predictive factors, such as momentum, that are not efficiently captured through traditional investing. Because systematic approaches depend on different performance drivers, their returns will likely differ from and complement traditional active strategies.
Get Invested to Get Ahead
Active investors should prepare to take advantage of shifting market dynamics as the year progresses. Above all, we think investors who are fully invest in the bond markets are less likely to miss out on today’s high yields and potential return opportunities.
