It may have been on the wind for the last few years, but it’s hardly a secret now that the three-decade-old bull market in bonds is finally winding down. Investors, many of whom were jolted from a state of complacency, have begun to take notice, pulling a record $62 billion out of bond funds in June alone. Some would say the so-called Great Rotation is underway. The crucial question, then, is “Rotation to what?” We suggest the answer to that great question is a combination of asset classes and alternative investments.
The Current Fixed Income Dilemma
Thanks in large part to the Federal Reserve’s unprecedented efforts to strengthen the economic recovery by keeping rates low, investors are currently facing the threat of rates rising from what are essentially rock-bottom levels. Indeed, today’s inflation rate is already higher than the yields on many “safe” bonds. There’s no reason to expect a big spike in interest rates any time soon, but there’s every reason to look for a gradual increase over the foreseeable term. As every investor who looked at his or her second-quarter statement knows, even modest moves can trigger losses in bond portfolios.
All of this has ominous implications for asset allocation portfolios built on the proposition that bonds act as a counterbalance to stock volatility. While that basic tenet has been true enough for the last 30 years, the good results are attributable to bonds’ total return, the huge majority of which came from their rising value. In the absence of price gains, bonds will offer little if any capacity to absorb stock market shocks going forward.
Strategies Offering Potential Solutions
The good news amid all this Modern Portfolio Theory gloominess is that today’s investors and advisors—unlike their 1940 counterparts—have more than credit quality and duration at their fixed income disposal. Nothing can perfectly replace bonds in the Fixed Income category without assuming some kind of interest rate risk, of course, but there are tools that can combine to fill the gaps. We feel that list should include asset class categories like High Yield, Floating Rate Loans, Emerging Market Debt, and Dividend-Paying Equities, along with non-traditional investment strategies found in liquid alternative and unconstrained bond funds.
When properly identified and properly used, these investments can help provide bond-like returns with uncorrelated volatility. That’s not to say the task is an easy one: it will take a fair amount of work to find a blend that best serves the Fixed Income allocation for any individual portfolio. Make no mistake: There is no “magic bullet” to fix the problem. But finding the right combination could serve specific investor goals in ways that stocks and bonds alone may not.
In this, the first of a two-part series, we’ll look at specific asset class categories that can be used as tools in the search for a fixed income alternative.
Asset Class Categories
It’s well known that high yield bonds offer more coupon than government bonds or higher-grade corporates. What’s less considered is their unrelated potential for capital appreciation—high yields can benefit from a rating upgrade (usually due to improved performance at the issuing company) or an upturn in the general economy.