Fear of Rising Yields…Again
The relationship between changes in interest rates and asset prices has been evident in 2021 as rising bond yields have spilled over to equity volatility. The path of interest rates is most commonly tied to bonds and the role of fixed income, but it also affects the pricing of equities and other cash-flow producing assets sensitive to assumptions of discount rates.
After ending 2020 at 0.93%, the 10-year US Treasury yield had risen to 1.54% at the end of February. A combination of fresh fiscal stimulus, excess personal savings (see chart below) and the relaxation of lockdowns all point to a potential for the US economic output gap to quickly close as demand recovers. The yield curve has responded by steepening to reflect an expectation of higher future growth and the potential for inflationary pressures.
The magnitude and even direction of rate changes has varied across maturities as shown in the chart below. The Fed has expressed its commitment to keep short term rates low (until at least 2023), and as a result yields have barely budged out to two years. It has less control over the long-end of the curve, which is where rising trends in inflation expectations can build.
With all the recent headlines on rising yields, some context is helpful for anxious bond investors. For a bond portfolio with an average duration of four years, a 0.5% parallel rise in yields would result in an approximate price decline of 2%. Keep in mind also that a steepening of the yield curve increases the potential for roll yield – or the price appreciation of bonds as they “roll” down the curve to a shorter maturity.
High-quality bonds still maintain a low-risk profile as a natural source for liquidity and relative strength amid equity market volatility. But muted return prospects across low-risk bonds are a significant challenge for portfolio return objectives.
There are a few ways we can offset some of the risk of rising yields while maintaining a reasonable return profile within fixed income. Migrating to a below-average duration, allocating to floating-rate securitized bonds and a strategic allocation to inflation-protected strategies all offer some ability to protect bond portfolios.
Ultimately though, in many cases we see fixed income serving a reduced role in client portfolios.
Expanding the Opportunity Set
Traditional stock/bond portfolios have enjoyed decades of a secular decline in yields amid a disinflationary backdrop. The correlation between stocks and bonds has been close to zero or even negative, enhancing the overall risk-adjusted returns for investors with a balanced mix of stocks and bonds.
The stellar returns of 2020 have left investors with a challenging environment looking forward. Strong performance from core fixed income to supplement returns during weak equity markets is likely over. Starting yields are simply too low to be accretive.
In recognition of this, Oxford’s investment team has sharpened the focus on Diversifier strategies. This allocation is expected to preserve important diversification characteristics of fixed income while offering a more compelling forward-looking return profile. This objective becomes even more important if the negative correlation of stocks and bonds fades – which is a plausible outcome in a stagflation environment.
These strategies are more divergent in nature, meaning they are less tied to the directional movement of stocks and bonds. The objective is not the avoidance of risk, but seeking strategies that pursue risk in a different way. There is a case for these strategies across a market cycle, but the current environment is particularly compelling with lower expected returns across traditional asset classes.
As a result, we believe now is a good time to revisit portfolio allocation decisions and reconfirm goals and risk tolerance. Low yields have changed the role of fixed income looking forward. High quality bonds are an excellent source of liquidity and counter-cyclical capital for a rebalancing opportunity, but expected returns are muted. Diversifier Strategies, which target alternative sources of return less correlated to stocks and bonds, are an important allocation to help fill the diversification gap left by low bond yields.
Oxford Financial Group, Ltd. is an investment advisor registered with the U.S. Securities and Exchange Commission. Registration does not imply a certain level of skill or training. More information about Oxford Financial Group’s investment advisory services can be found in its Form ADV Part 2, which is available upon request. The above commentary represents the opinions of the author as of 3.8.21 and are subject to change at any time due to market or economic conditions or other factors. The information above is for educational and illustrative purposes only and does not constitute investment, tax or legal advice.