In a year of economic optimism, as we emerge from the recession brought on by Covid-19, we have seen substantial gains in the equity market while fixed income has wavered. Through the first quarter of 2020, fixed income--specifically the higher quality bonds--was the best performing asset class on the tailwind of the ten-year treasury yield dropping 76%. However, that same saving grace in 2020 is now a portfolio detractor. Currently, rates are hovering around pre-covid levels at 1.60%, but the general consensus remains that they will continue to increase. Based on the duration and convexity of the US aggregate bond index, for every 1% increase in yields the value your bond holdings will decrease by approximately 6.3%. So how high will rates go? To put it in perspective, the highest rates got in the last recovery was about 4%. However, in the 1980s they were as high as 15%. I know thinking about rates getting to 15% is a frightening picture, but there is little chance of them ever getting back to those levels due to a few anti-inflationary drivers such as technology and the Fed’s better understanding of monetary policy. With that said, I do believe there is a good chance rates will get back to the mid-3s in the next few years. So, with the ten-year treasury set to double in the next few years, should investors abandon fixed income? Our team at HPK sees the importance of retaining assets with lower correlation to equities in order to provide downside protection in the event of corrections. However, we utilize different strategies to mitigate the effects of rising inflation. Below are some strategies to reduce your interest rate sensitivity. It is important to understand your financial situation before implementing any of the following.
- Reduce your fixed income exposure: Given the outlook over the next 3 years, being overweight equities vs fixed income has the potential for higher returns. However, your portfolio will experience greater declines in the event of market pullbacks. Investors should only consider straying from their longer-term allocation if they have enough assets to cover their liquidity needs in the event of longer drawdowns as well as having the fortitude to stay invested.
- Supplementing your core fixed income: Not all fixed income is created equally. The three risks associated with fixed income investments are interest rate risk, default risk and liquidity risk. Higher quality bonds take on more interest rate risk but have lower default and liquidity risk. Supplementing your investment grade holdings with floating rate and high yield can reduce your interest rate risk, but at the cost of higher credit risk.
- Supplementing your bonds with annuities: This is a strategy that retains the low/zero interest rate and credit risk but has higher liquidity risk.
As you can see, both keeping your current bond allocation and/or implementing some of the alternatives have pros and cons. Every investor’s circumstances are different, so it is important to talk to a financial advisor about your specific situation. Our team at HPK would be happy to help you navigate these difficult waters.