The benefits of that diversification are perhaps most evident during equity bear markets, as indicated by the chart above, which illustrates the growth of $1,000 invested in stocks, bonds, and a diversified portfolio during two of the worst performance periods in recent history (Figure 2). Because bonds add to portfolio efficiency, they help to balance risk and reward and provide a hedge against potential equity market drawdowns and potential inflation.
Can specific areas of the fixed income market provide increased return potential in the next 3 - 5 years?
Answering this question begins with examining the yield spread. The yield spread is the difference between yields on differing debt instruments of varying maturities, credit ratings, issuer or risk level. When spreads narrow, the yield difference is decreasing, indicating that one sector is performing more poorly than another.
Over the course of 2020, the yield spread narrowed, and rates fell, causing income potential to decline. As a result, higher quality non-Treasury sectors within the U.S. Aggregate Index may offer limited returns with lower risk potential. While yields of lower quality sectors are more compelling, security selection is paramount at this stage, making active management increasingly important for implementing multi-sector strategies, which can offer the opportunity to balance stability with income.
Examples of areas of potential opportunity include investment grade corporate bonds, structured credit,1 emerging market bonds and U.S. high yield bonds. Gaining more targeted exposure to these sectors can be achieved through a variety of means, including through active management and portfolio construction and the use of specially structured products, such as closed-end funds and private credit. Given the dynamic and evolving nature of opportunities within the bond market, customized portfolio construction and the use of active bond managers, which have demonstrated skill in delivering strong performance in these areas, will continue to be a focus for IMG.
Are the traditional risks of owning bonds, such as inflation and debt, still relevant in a Fed lower-for-longer world?
The short answer is yes. Inflation risk is still relevant, although it's expected to be less of a concern for the next several years, due to continued Fed intervention. The Fed seems to have little ability to push inflation higher in the current environment, though they have blunted deflationary forces. While 1970s-style inflation is not expected, some increase in core inflation (i.e., excluding food and energy) is anticipated and could become an issue longer term.
"If inflation does increase, the Fed may raise rates, or it might continue to repress rates for some period of time as a means of trying to mitigate inequality, even while the market starts pricing inflation into spreads," Canally said.
While inflation may be less of a consideration in the short term, debt most likely will contribute to slowing overall gross domestic product (GDP) growth in the long term.
"From a corporate bonds perspective, the Fed hasn't explicitly picked winners and losers," Canally said. "However, businesses with fundamental flaws are not likely to survive, even if easy credit extends their survival time." That's because easy monetary conditions can encourage too much risk-taking and marginal investment projects (i.e., planting the seeds of the next credit cycle). As a result, even a short-lived inflationary spike could hurt struggling companies if they need to roll debt when inflation has increased their cost of borrowing. Delays in pricing power (vs. input costs) could also negatively impact some businesses. However, the biggest risk of inflation may come in the form of lower quality credits.
Can another asset class replace bonds in a 60/40 portfolio?
There is no silver bullet for replacing the traditional role that bonds play in a 60/40 portfolio. There are, however, select opportunities, both within and outside of fixed income, which have the potential to deliver some of the investment and yield potential that is challenged in the current environment. For example, using cash as a strategic asset (as a longer-term holding) can serve as a risk buffer, but cash has its limitations when it comes to income and growth.
An appropriate allocation to low-cost fixed annuities, particularly in a retirement portfolio, can provide many of the benefits of bonds as well as position the portfolio to produce a steady income stream in retirement, if that is an objective. It's important to keep in mind that fixed annuities are different than bonds, in that they are generally less liquid, cannot be turned into income until 59 1/2 and once annuitized the income cannot be changed. When incorporated as part of diversified income plan, low-cost fixed annuities can serve as the ballast for a client's income needs, allowing for the use of other differentiated, income-oriented solutions based on their goals and objectives.
Other low or non-correlated investments and hedge fund strategies can lower portfolio volatility. However, Canally notes that access and liquidity can be limited. Investing in real assets (timberland, farmland, direct real estate, private equity, etc.), can offer the potential for higher returns and potentially lower volatility but as a tradeoff for liquidity. While preferred stocks and convertible bonds may offer outsized returns, they also tend to be smaller capitalization securities trading in smaller markets, which can result in liquidity issues.
The consensus? There is no exclusive replacement for bonds as a strategic asset, and owning substitute asset classes often comes at a cost, which is higher risk. Although, there are assets that provide certain bond-like attributes which can be used, if available and appropriate, to augment an investor's portfolio.
Key takeaways for investors
IMG believes that investors should consider the following as they seek to generate income and growth from their investment portfolios in the coming years.
- The role of bonds will continue to be challenged. The current low-rate environment and the prospect for continued fiscal and monetary policies, aimed at boosting economic growth, will likely result in muted returns and yields for bonds for the next several years. This not only increases the risk of inflation but may also continue to challenge the role of bonds in a traditional balanced portfolio in the coming years, making it increasingly difficult to hit absolute return targets in a prolonged low-return environment.
- Bonds are still highly efficient in terms of risk-adjusted returns. IMG believes bonds should continue to play an important role in helping to balance risk and reward while serving as a potential hedge against equity market drawdowns. However, how one goes about structuring the bond portion of a portfolio will look somewhat different than in the past.
- Opportunities for higher yields and return potential still do and likely will continue to exist. Although, accessing those opportunities may be accompanied by increased risk, and investors may need to be nimble to take advantage of them. Where appropriate, IMG is allocated to investment grade corporate bonds, structured credit, emerging market bonds and U.S. high-yield bonds via the use of active management and customized portfolio construction.
What does this mean for your planning going forward?
A disciplined approach to managing investment assets, based on deep analysis, research and experience, will be critical in the years ahead to remain on track toward your goals while keeping risk in check. However, this can be hard for most people to achieve on their own without access to a deep bench of expertise and resources focused exclusively on day-to-day portfolio management. This is where managed accounts can play an important role in helping you to optimize your planning and investments, and ensure all decisions are fully aligned with your goals, timeline and risk tolerance.
Your TIAA advisor can help you develop a comprehensive plan focused on generating the income and growth you need, while helping to manage inflation, market volatility and other risk factors. To learn more about the benefits of planning and active management, schedule time to meet with your TIAA advisor today.