The Adviser You Can Talk To Podcast
February 9, 2022
Rising inflation and the prospect of rate hikes have been a one-two punch to the bondA financial instrument representing an IOU from the borrower to the lender. Bond issuers promise to pay bond holders a given amount of interest for a pre-determined amount of time until the loan is repaid in full (otherwise known as the maturity date). Bonds can have a fixed or floating interest rate. Fixed-rate bonds pay out a pre-determined amount of interest each year, while floating-rate bonds can pay higher or lower interest each year depending on prevailing market interest rates. markets this year—and fixed-income investors may be feeling the pain. In this kind of environment, why own bondsA financial instrument representing an IOU from the borrower to the lender. Bond issuers promise to pay bond holders a given amount of interest for a pre-determined amount of time until the loan is repaid in full (otherwise known as the maturity date). Bonds can have a fixed or floating interest rate. Fixed-rate bonds pay out a pre-determined amount of interest each year, while floating-rate bonds can pay higher or lower interest each year depending on prevailing market interest rates. at all? Our experts have that answer and more. They discuss:
A glance at the headlines might make you want to run for the hills when it comes to fixed-income investing in 2022. The returns from bonds in the next five years may not match what they were in past decades. But that doesn’t mean bonds don’t have a key role to play in your portfolio. Listen now to find out why.
Hello, I’m Charlie Toole, a portfolio manager at Adviser Investments, and welcome to another The Adviser You Can Talk To Podcast. The two most prominent headlines in the financial press have been inflation and the Federal Reserve signaling they will begin to hike rates. This has been a one, two punch to the gut of bond investors as yields have risen to their highest levels since the pandemic started, and that has sent prices, which move in the opposite direction of yields, down to start the year.
Like the beginning of 2021, bonds have fallen to start 2022, and the Bloomberg US Aggregate Bond Index is down more than 2% so far this year. Clients want to know how inflation and rising interest rates may impact their portfolio, and I’m joined by three of my colleagues who are subject matter experts on these topics.
First guest today is Chris Keith. He is the portfolio manager on our Managed Bond Program, and he’s a 30-year veteran of the bond market, which is to say that he’s been around for a few inflation and rate spikes. Chris, welcome to the podcast.
Charlie, it’s good to be here with us this morning.
We also have Jeff DeMaso. He is Director Of Research here at Adviser Investments, and he oversees the Portfolio Managers and the Research Analysts on our investment team, as well as overseeing our core mutual fund portfolios. Jeff is also the co-editor of the Independent Adviser For Vanguard Investors newsletter. Jeff, welcome to the podcast.
Hey Charlie, thanks for having me.
And finally, we have Jurbala. He is a Quantitative Investment Manager here at Adviser, and he manages our tactical ETF strategies, specifically the tactical high income and tactical multi-asset strategies. These are two strategies that focus on segments of the bond market, and Josh will be able to give us a qualitative and quantitative view of the bond markets. Josh, welcome to the podcast.
Hey Charlie. Good to be here guys.
So I’m going to do something a little different today with the format and keep it a Q&A style because we’ve been hearing a lot of questions from clients about the bond market and about inflation. And Chris, I’m going to start with you, and the most popular question that we’re getting from clients. And after a rough start to the year for bonds and a difficult year last year, many clients are asking the question, “Why own bonds at all?”
Well, Charlie, it was a rough start to the year and recent market action may not be a complete surprise, but there’s no denying that the start to this year has been a disappointment for bond investors. We anticipated two key themes heading into ‘22 that would impact the bond market. First was inflation and that it has enough momentum heading into the year to push it higher still. And second, we knew that the Fed would be under increasing pressure to do something about it, and now they seem poised to do so. By the way, we see January’s inflation report later this week, so we’ll have some fresh data, but once again, momentum is to the upside there.
Now, as for the bond market, it’s similar to every other asset class, and then it goes through challenging periods, but that doesn’t prevent bonds from doing their job. High-grade bonds maintain a low correlation to stocks, and that means they continue to act as a portfolio diversifier. So despite the disappointing start to the year, bonds still act as a safety buffer in your portfolio, and the silver lining is that with every dollar added back into the market or reinvested back into additional fund shares, it’s now earning a higher yield, which is something we’ve been waiting for.
So Charlie, I believe bonds will come around and investors will ultimately be pleased with the role that they fill in their portfolios.
Hey Chris, that’s a really complete answer. We’re definitely going to hit on those topics again and again. If I could just add, because you mentioned the rough start to the year or the rough year last year, the disappointing year. Just for a bit of perspective, we’re talking a decline of 2% for bonds. That’s a bad year in the bond market. It’s a bad afternoon in the stock market, right?
Let’s keep a little perspective when we’re using some of these disappointing terms.
I just thought you’d cover that in your segment JD.
Well, no, that’s a great point, Jeff. A bad year in the bond market is certainly a bad hour in the stock market, given some of the volatility we’ve seen so far this year. And Chris mentioned higher yields and it’s something that we’ve been waiting for as investors, and the Fed is signaling that they’ll be raising rates.
So if clients aren’t asking why own bonds at all, I guess the companion question or the other question that we get is, “With interest rates starting to rise, shouldn’t I sell my bonds?”
Yeah, it’s a great question. And look, if we could time the move in interest rates, sure, we could probably improve returns, but that is far easier said than done. It is no easier to time the bond market than it is to time the stock market, though. We’ll hear from Josh, who thinks that it’s an activity worth pursuing and I value that perspective, but let’s specifically look at those times when the Fed was hiking interest rates.
We can look back at the past four cycles, and I looked from when the Fed first started raising interest rates until they first cut interest rates. And we can go back and look, 1994 to 1995, bonds returned 8%. And when I say bonds, I’m looking at Vanguard Total Bond Market Index, that’s your high-quality treasury bonds, mortgage-backed security bonds, corporate bonds, investment grade, broad bond exposure.
So again, okay, that first cycle, bonds gained 8%, 1999 to 2001, bonds gained 13%, 2004 to 2007, bonds gained 16%, in 2015 to 2019, bonds gained 13%. So 8% to 16%, maybe that’s nothing to write home about or get excited about, but those are positive returns from bonds while the Fed was hiking interest rates, making things more difficult for investors.
Yeah. And one other way to look at that, people talk about today, the low yield that we have and how that’s a headwind in these rising rate environments. Well, that was the same during the last rate cycle, and we still had double-digit, as you mentioned, 13% returns. So even though we’re at a very low base, there’s still some returns to be had in the bond market when rates are rising.
All right, Josh, when our asset class underperforms, clients always look for alternatives, and one alternative that clients have been asking about are Treasury Inflation-Protected Securities or TIPS.
So can you give us a quick primer on what TIPS are, and if they’re appropriate for clients in an inflationary and rising rate environment?
Yeah, sure. It is a question we’re getting a lot recently. TIPS are on everyone’s minds. They’re basically bonds issued by the U.S. Treasury that are indexed to inflation, and that just means that the income or the interest paid on TIPS will increase at the rate of inflation. So in that way, TIPS are basically designed to preserve your purchasing power in an inflationary environment, just so your income can keep pace with rising prices, and there’s definitely benefits to TIPS.
Since they’re Treasurys, they’re guaranteed by the U.S. government. So if you buy actual TIPS bonds and holds a maturity, you’re pretty much guaranteed to receive your principle investment back. So in that way, they have no credit or default risk like corporate bonds do. And TIPS prices are usually stable.
TIPS can certainly be helpful asset in a portfolio at times. Holding TIPS can provide a useful hedge against inflation, but I would just keep in mind that TIPS are also adjusted based on changes in the consumer price index, the CPI that everyone talks about. And that’s just an aggregate index of prices that might not actually accurately measure the inflation that an investor experiences. So just keep that in mind when investing in TIPS. It might not offset the prices you’re actually paying.
Obviously, TIPS, they’re seeing a lot of demand recently. They’ve returned over 6% last year, which was definitely impressive considering most bonds were negative. Are they appropriate now? Back to your original question, I’d caution against buying in right now because there are certainly risks. They’re Treasurys so they carry a ton of interest-rate risk. So they’ve actually fallen recently as yields have risen. They’ve fallen as much as regular Treasuries have, so just keep that in mind. TIPS are down 2% through January, so they can certainly lose money.
And then the other risks I would mention would be they’re driven by sentiments. So when inflation expectations are high, as they have been for the past year, demand for TIPS skyrockets, and this can be dangerous if the boat gets overloaded to one side and then everyone tries to jump at the same time and sell TIPS.
So just remember, especially now when inflation’s on everyone’s mind, markets are forward-looking. So just because inflation’s high today, if investors think that inflation’s going to fall, they’re going to sell TIPS in a hurry. So that’s just something to keep in mind. Last week, we actually saw the largest weekly outflow from TIPS since March 2020.
So there’s also technical reasons I won’t get into here, but the Fed’s been a big buyer of TIPS on their balance sheet. Everyone’s been talking about that too, and that could cause further volatility as they eventually sell down their balance sheet. So keep that in mind.
Josh, that’s a great point that a lot of this inflation has been priced into the market because inflation has been a headline for just about a year now, but I mentioned at the beginning, your Multi-Asset Income strategy. I would think that TIPS is one of those assets that’s multi-asset in your strategy. Can you talk a little bit about that as well?
Yeah, exactly. So, I talked a little bit about the benefits of TIPS and then the risks. They’re clearly a double-edged sword when fighting inflation, and that’s why we do hold them as just a tactical tool in our multi-asset strategy, one of a few that we might rotate in and out of, depending on the risk and return potential.
And so, for this reason, this is why I say I’d just be a little wary because we actually held TIPS in that portfolio for most of last year, generated a decent return, but then when TIPs started selling off, we sold early this year. And so right now, it’s signaling too much risk to hold for the long-term right now.
Good. Okay. I’m going to pivot away from TIPS and go to the muni market. And Chris, this is an area where you have a lot of expertise. Last year, munis performed well, but this year they’ve struggled along with all other bond asset classes.
So has something changed this year? Is there a dynamic in the Muni market that investors should be paying attention to?
Charlie, there’s nothing wrong with munis or the muni market for that matter. They did gain 1.5% last year while their taxable bond counterparts declined 1.5% last year. So I think munis had some repricing to do as interest rates headed up, and that’s a good part of what’s going on here.
Digging a little deeper though, the underlying fundamentals of state and local municipal finances are in pretty good shape. States are rolling in cash right now, as revenue collections have far outpaced forecasts, and many states are going to end the fiscal year with a budget surplus.
Additionally, states have received, or at least they will receive their share of $195 billion in federal COVID relief funds. Those dollars have gone a long way to shoring up finances. And at the local level where property taxes are the lion’s share of revenue for the cities and towns, a booming housing market is doing its part to keep local coffers full.
Munis have a loyal band of followers who are attracted to the tax exemption on interest payments, and I don’t expect them to just up and walk away from the muni market en masse. They’re going to continue to enjoy the tax exemption, and they’re always going to look for a way to have access to it.
Having said all this, munis are still bonds, and they’re going to be impacted by interest rate moves. And as for the time being, those moves have taken prices lower and yields higher, but no, there’s nothing wrong with the muni market. It’s just what’s going on in the bond market in general.
Okay. And Jeff, given the negative returns for bonds, the low-yield environment, the high inflation environment, we’ve seen a lot of articles, not only this year, but in past years, talking about the traditional 60/40 portfolio, 60% stocks, 40% bonds, not being the same as what it was in the past. What should clients do with that 40% in an inflationary rising rate market?
Oh man, Charlie, I’ve been reading about the death of the 60/40 portfolio for, I don’t know, a decade now, whatever it’s been. It’s been a while. Look, okay, let’s talk about bonds. I’m going to come back to some of the points that Chris made in his opening comments as well here.
Well, the return from bonds going forward is not going to be what it’s been over the past 30, 40 years. The yield today is a pretty good predictor of what returns are going to be over the next, whatever, call it five to 10 years or so. So if bonds are yielding, whatever, 2% to 3%, then that’s kind of what you can expect to earn.
Part of the answer is we need to adjust our expectations for returns, but as Chris said, that doesn’t mean that bonds don’t have a role in our portfolios. And the primary role that they’ve always played in a 60/40 portfolio has been to control the amount of risk you’re taking, particularly the amount of equity risk you’re taking, to help cushion your portfolio when we go through those stock bear markets, when stocks are down 20, 30-plus percent. You’re using bonds as your number one lever to help offset that risk.
When we’re thinking about our core portfolios, which are a little bit different than the tactical portfolios that Josh is building, but we’re trying to build a portfolio that, number one, is going to provide that protection. We want it to offer that protection. And number two is, since we’re thinking a little bit longer term with these portfolios, we want it to be able to perform well in different environments.
We’re not just taking one big bet that interest rates are going to rise, or that interest rates are going to fall. We want a portfolio that can do reasonably well, given a number of different unknown future outcomes.
One final point to add, and then we can maybe talk a little tactical here, because it’s a bit of a different answer, but I hear a lot of people saying, “Okay, with that 60/40 portfolio, get rid of bonds, don’t have that in the 40, use ‘alternatives.’” The problem with that is that alternatives just mean you’re taking on more risk, and they aren’t providing that consistent predictable protection when stocks decline.
To give one specific example, it’s probably, hopefully still a little bit fresh in all our minds. Let’s go back to the first quarter of 2020 when COVID first struck. The S&P 500 fell about 20% in the first quarter. Vanguard Total Bond Market Index, high quality bonds gained 3%. Such a reliable offset to the stock market decline.
If we look at the so-called alternatives, high-yield junk bonds. Down 10%, commodities, down 21% or so, real estate, down almost 25%, utility stocks, down 14%, high dividend stocks, down 24%, Vanguard’s alternative strategies fund, which is kind of like their hedge fund catch all for alternatives, down 13%. I think you get the point, these alternatives aren’t going to be there.
They may be, they may do well when stocks decline next, but do you have that same level of confidence as you do with high-quality bonds? I certainly don’t.
Yeah, neither do I. And I agree, the bonds are there as your buffer and as you just mentioned, it’s a great example of how bonds can cushion the blow when stocks are falling. And Josh, Jeff mentioned high-yield as an alternative that didn’t really hold up all that well in a bear market as an alternative to high-quality bonds.
I mentioned the Tactical High Income strategy at the beginning. Now, that’s a strategy where you’re doing something a little different and being more tactical with high yield. How does that differ from just a traditional high-yield allocation in your portfolio?
Yeah, that’s a good question. I agree with Jeff. I see a lot of potential benefit in high-yield, but obviously, we know there’s no free lunch in investing, so that higher yield comes with a price and that means higher risk. And Jeff alluded to the fact that it drops further than you might expect, especially if you’re holding it within the bond portfolio within the bond sleeve of your portfolio.
So especially for conservative investors or someone who’s withdrawing income and taking out at the time that those bonds are falling, that’s what we’re trying to protect with a tactical strategy. We’re taking basically an active approach and attempting to make the return stream more consistent and predictable, as Jeff said. We’re just taking a more active kind of doing near-term trading to trade in and out of higher high-yields.
And so, we’ll invest fully in high yields when it’s trending, which is a lot of the time. High-yield bonds trend or deliver consistently higher income when economic times are good, and that’s most of the time, but obviously, those big economic shocks can cause prices to sell off pretty suddenly, and that’s what catches investors by surprise, and is why some people can’t hold them for long term in their buy and hold portfolio.
And so, our tactical income strategy just kind of approaches high-yields head on, and we’ll try and extend and increase exposure during those trending periods to high-yields, but then go entire half or entirely to cash when high yield is more risky and selling off. And so, that’s pretty much our approach through a tactical lens, is improving the risk return profile of high-yield bonds.
That’s great. So it sounds like you’re almost taking different allocations based on what your tactical models see in the market?
Exactly. It’s just a plan in place to help with both offense and defense involved with investing in high-yield.
All right. We’re going to wrap this up with the final question for each of you. You each have your own discipline where you’re managing client money. How are you investing in those portfolios to diversify the bond holdings and protect clients from inflation and rising rates? Chris, what are you doing in the Managed Bond Program?
Well, we continue to focus on high-quality bonds because high quality bonds do what they do when investors need it the most. We’ve always had a strict set of risk controls and a discipline that we adhere to. Part of that is limiting the position rates of individual bonds and the portfolios we manage.
We also limit how far out we go on the maturity spectrum. So we don’t own 20-, 25- and 30-year maturities. Rather, we have concentrations on the front end and bonds with shorter maturities, which may be less impacted by rising rates because your bond has a shorter lifespan. It matures sooner.
And I love it when our bonds that we hold until maturity, when they come due and we can reinvest principal back into the market at higher rates. Right now, we continue to favor shorter maturities over longer ones, and we look for higher fixed coupons that are more defensive. And of course, we take the time to search for every extra basis point that we can find.
Occasionally that takes us to the lesser-known market of taxable munis, where investors can sometimes find higher yields than they would otherwise find in parts of the high grade corporate bond market, Charlie.
Okay. Jeff, how about you and the core mutual fund portfolios?
Yeah. Well, like Chris, we don’t feel like we need to own the entire bond market, or necessarily load up on long maturity bonds, which are going to be hit the hardest when rates rise. Like I said, we’re trying to build something that’s predictable and can perform reasonably well, whether rates are going up or not.
But part of our portfolio that’s geared towards protecting against rising rates that we’ve found some opportunity in is in the mortgage-backed bond part of the market. We’ve partnered with a niche fund that’s hunting for unique bonds in that space, and it’s finding bonds that are outside of the benchmarks. It’s doing things a bit different.
And so far, it’s shown a nice ability to protect when rates rise. It tends to be our trailing fund when rates fall and everything’s good in the bond market, but it’s providing a nice piece of diversification for our portfolios.
And Josh, how about the tactical side? How are you protecting against inflation and rising rates?
Yeah. Well, I always say that the great thing about tactical is that most of the research has been done ahead of time. Right? I don’t have to be making too many subjective decisions kind of in the moment right now. So what the portfolios themselves have been doing has been based on that quantitative systematic approach and rules-based system that we’ve developed over years. And it mostly gravitates to what’s worked recently, and it manages the risk in different bond segments, and strategically uses cash if necessary.
And so right now, our Multi-Asset Income strategy is pretty well defensive right now in cash. There are just fewer opportunities to generate even a small amount of income without taking on undue risk. And so it’s just trying to manage through the environment, which allows it to be opportunistic without… It protects capital while in cash, and then if positive trends reemerge and bonds stabilize, it can reinvest at hopefully higher yields.
And so, Multi-Asset Income is basically holding mostly cash, a little of high-yields and senior loans right now, and holding some agriculture and commodities exposure just for that diversification benefit. And then our high-yield strategy also got defensive pretty early this year into January. It’s sitting entirely in cash, just waiting for those positive trends we talked about in high-yields will reemerge before it reinvests. And then most of our other strategies are more growth-oriented, but also have gotten relatively defensive considering the volatility we saw last month.
Yes. As volatility rises, defense and defensive assets play a more important role.
And even though the Fed is poised to hike interest rates, that doesn’t mean investors should sell their bonds. As we discussed today, bonds play an important role of defense in your portfolio. And while there are other strategies that you can take advantage of to mitigate rising interest rates and rising inflation, you shouldn’t put all your eggs in one basket. And as we’ve mentioned here, staying diversified is the best path towards financial success.
Chris, Jeff and Josh, thank you for joining me today. This has been Charlie Toole, Chris Keith, Jeff DeMaso, and Josh Jurbala from Adviser Investments, thanking you for listening to The Adviser You Can Talk To Podcast.
If you’ve enjoyed this conversation, please subscribe and review our show. You can check us out at adviserinvestments.com/podcasts. Your feedback is always welcome, and if you have any questions or topics that you’d like us to explore, please email us at email@example.com.
Before closing, I’d like to thank Kailey Steele and Ashlyn Melvin. They do all the hard work making this podcast possible. Thank you for listening.
Podcast released on February 9, 2022. This podcast is for informational purposes only. It is not intended as financial, legal, tax or insurance advice even though these topics may be discussed. Information and events addressed in this podcast, as well as the job titles, job functions and employment of the podcast’s participants with respect to Adviser Investments, LLC may have changed since this podcast was released. For more information on each individual featured in this podcast, see the Our People section of our website.
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TIPS can be a double-edged sword when fighting inflation. But they can be a tactical tool in a multi-asset strategy.
TIPS can be a double-edged sword when fighting inflation. But they can be a tactical tool in a multi-asset strategy.
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