The same environment that has allowed stocks to post their seventh consecutive monthly gain has caused a world of hurt in the sovereign debt market.
Economic growth is the main culprit. As GDP expands into the second quarter, the Fed is becoming convinced that the recovery is enough to maintain the improvement in jobless claims. Faced with less need for the government to continue its aggressive bond buying program, investors fled from the fixed income markets in May. Long-dated U.S. Treasuries were down nearly 10% on the month, and the Barclay Aggregate Bond index finished at a new 52-week low (see chart below).
Meanwhile, Japanese stocks plunged mid-month, as that country’s shares are being supported more by the friendly Abe regime than by a pickup in economic activity. The 7% drop in the Nikkei caused a ripple effect in Europe and the U.S., but even a swoon of that magnitude didn’t quell the selling in fixed income. At the end of the month, domestic stocks were able to keep the bulk of their gains.
At this point, the writing’s on the wall. Fixed income is not the panacea it has been for the last decade. With rates still very low, they seem to offer more risk than return—and investors are voting with their pocketbooks. Although I’m not proposing a wholesale elimination of bonds from client portfolios, it’s time to consider some alternatives.
Consider reducing exposure to Treasuries, for starters. Since these securities are the most sensitive to changes in rates, and there doesn’t seem to be a compelling reason for rates to head lower, U.S. sovereign debt is not a compelling choice. High-quality corporate and mortgage-backed issues should give a little more downside protection. For those seeking diversification, commodities are an interesting choice. Raw materials prices have not kept up with gains in stocks, and should recover if the economy keeps humming along.
The bottom line is that fixed income investors need to consider their options in the current economic environment.