by Brian Erickson, Vice President of Fixed Income Research and Strategy, Ameriprise Financial
The Federal Reserve officially hit the pause button in January after steadily hiking short-term interest rates to 2.5 percent over a more than three-year period. In 2015, high-quality fixed income investments yielded practically 0 percent, an understandably challenging environment for many investors. Fast-forward to today, and yield seems to be much easier to come by in the bond arena. Investors are able to pursue more attractive yields without stretching into speculative grade bonds or buying longer-term debt. Given this long-awaited shift, we believe this is an opportune time to revisit your fixed-income investment strategy and consider a return to ”the basics.”
Economic trends offer the Fed leeway
What encouraged the Fed to bring at least a temporary end to its rate hikes? For one, stubborn inflation, which topped 2 percent last year, has been softening since December. Looking back on the past decade, inflation remained subdued even as tight labor markets raised the risk of higher wage inflation; historical inflation patterns have simply not played out. Technological advancements, globalization and aging demographics also tempered the inflation threat. Overall, the Fed faces little immediate pressure to resume interest rate hikes, indicating that we won’t likely see a return to tightening mode in the near term.
Coping with a challenging environment
In the 1990s and early 2000s investors could earn reasonable returns simply by tilting their bond investments toward high-quality fixed income. More recently, they had to assume greater levels of risk to simply beat inflation. In some cases, investors might not have been thinking far enough ahead on the level of risk they were taking on to get that yield.
At the same time, for investors seeking to preserve capital, investing in tried-and-true short-term Treasuries, money markets or certificates meant another sacrifice; they would lose ground to inflation in an attempt to mitigate risk. Others may have been tempted to reach for yield through lower-rated debt or longer maturities, following a non-traditional course simply to preserve buying power.
Fed rate hikes changed the landscape
The Fed’s policy shift, beginning in 2015, was a game changer for fixed income investors. Old fashioned “core” bond investments (as measured by the Bloomberg Barclays U.S. Aggregate Index) yield 2.79 percent as of May 29, 2019, outpacing inflation.
All of this creates an opportunity to revisit the capital-preservation strategies of more traditional approaches to bond investing. Investing in buy-and-hold laddered portfolios of CDs or high-quality bonds once again may be appropriate for investors seeking a return of investment rather than a return on investment. By holding to maturity, investors are poised to avoid market risk when principal protection is a priority.
Today, we favor intermediate-term bond allocations for investors seeking total return or income as one way to take advantage of moderately higher yields in high quality fixed income instruments. In short, we believe it’s back to the basics with plain-vanilla, intermediate-term bond investments playing a lead role.
Be mindful of credit risk
Over the past few years, fixed income investors were forced to extend themselves on the risk spectrum or pursue more complex strategies to generate competitive yields. Credit risk is the risk that a bond issuer could default on repayments of that debt — not exactly the outcome bond investors seek. In the current market, we recommend shifting course and selecting fixed-income investments that are more traditional.
We believe a credit cycle pivot occurred in the fourth quarter of 2018, casting a shadow on the riskier segments of the bond markets. In addition, federal spending stimulus enacted in 2017 is set to end late this year, potentially slowing the rate of economic growth. This environment may call for a more selective approach to bond investing. Now may be the perfect time to reassess credit exposure and to refocus on high-quality bonds.
As a general rule, we favor fixed income allocations of 80 to 90 percent investment grade rated debt securities or actively managed funds with a high-quality core bond mandate. Specifically, we currently find Treasuries, agency mortgages and investment-grade corporates attractive opportunities to capture competitive yield. Exposure to these sectors of the bond market are readily available in intermediate-term core bond funds, or a buy-and-hold laddered approach using high-quality debt securities.
Rebalancing and fine-tuning
If you believe your portfolio may have wandered from its targeted allocations, talk with your advisor to see if rebalancing to a core approach to bond exposure makes sense for you. We believe it is better to make these changes in sanguine times, rather than amidst pronounced market ups and downs.
Determining your risk tolerance does not start with how much income or yield is required. It begins with how much risk you are willing to accept. Given the late stage of the market cycle in which we now find ourselves, now would be an ideal time to revisit your risk tolerance with your advisor. You may want to consider shifting to a more conservative posture in your fixed income portfolio. This may reduce portfolio variability and allow you to stay invested to benefit from long-term potential returns.
Just as important is to consider which investments to leave out of your asset mix. We believe there is higher risk associated with investing in borrowed funds or using embedded leverage, especially in high yield or emerging market debt. Today, we believe you are likely to benefit more from a durable, core bond allocation that can serve as a point of stability against the market ups and downs that may lie ahead.
In closing, we believe this is the right time to talk with your advisor and consider a return to the basics for reasonable yield and less risk in your fixed-income portfolio. Your advisor can provide you with personalized recommendations for a diversified portfolio and solutions to help protect you from uncertainty.