Bond yields are likely heading higher in 2021, which suggests a shift in strategy for fixed income investors, according to Kathy Jones, chief fixed income strategist at the Schwab Center for Financial Research.
In her 2021 Fixed Income Outlook, Jones says the 10-year Treasury bond yield could range between 1% and 1.6% in 2021, reaching the upper end of that range if the U.S economy “posts a solid recovery in the second half of next year,” following the broad availability of a vaccine for the coronavirus. Another fiscal aid package, as large as $2 trillion, would also boost growth, writes Jones.
Short-term rates, however, are likely to remain near zero throughout next year because of continued low-rate Federal Reserve policy. The market expects the Fed won’t raise short-term rates until 2023, according to Jones, and that is exactly what the Fed indicated in its economic projections released in June and again in September.
“We don’t expect any major policy changes from the Fed for at least the first half of 2021,” Jones writes. “Even under an optimistic scenario for the distribution of a vaccine, the economy will take time to rebound to pre-pandemic levels.”
Moreover, under the Fed’s new policy guidelines that allow inflation to top its 2% target for a sustained period until the unemployment rate falls to a level consistent with full employment, Jones doesn’t expect the Fed will raise rates.
Given this outlook, she writes that investors can expect to collect higher coupons on the long end but recommends they keep the average duration of their bond portfolio low, waiting until yields begin to rise before adding long-term bonds to their portfolio.
While Jones suggests eventually moving out the yield curve, she cautions against moving down in credit quality to collect higher coupons. “The risk/reward in the lower tiers of high yield or municipal bonds looks unattractive to us based on current valuations.”
Jones doesn’t expect inflation will be a risk for investors for quite a while but suggests that investors still consider inflation-linked bonds like Treasury Inflation Protected Securities (TIPS) to provide some inflation hedge for when yields gradually rise over time.
Five-year and 10-year TIPS can outperform comparable maturity Treasurys when inflation is below the Fed’s inflation target, leaving room for capital appreciation if inflation rises, according to Jones. She suggests replacing some Treasury holdings with TIPS.
Jones also recommends that U.S. investors diversify their bond holdings geographically, adding foreign bonds, especially emerging market bonds, based on expectations for a weaker dollar and stronger global growth. “Yields for emerging market bonds are still slightly above the long-term average,” writes Jones.
She suggests that investors “concentrate the bulk of their bond portfolios in core bonds that have higher credit ratings and lower default risk.” Those willing to take more risk could allocate up to 20% of their bond portfolios to a combination of high-yield and emerging market bonds as well as bank loans and preferred or convertible securities.
As in all outlooks, there are uncertainties. If Congress doesn’t come up with a strong economic relief package in early 2021, growth could falter and unemployment could rise, resulting in lower Treasury yields or potentially lower-than-expected rise in yields.
On the flip side, the pandemic could end sooner than anticipated, leading to a stronger-than-expected economic recovery and higher-than-expected inflation.
“Overall, we see 2021 as a potentially more challenging year for fixed income investors,” in large part because the path of the pandemic remains uncertain, writes Jones. Given the wide range of potential outcomes, she suggests that investors focus on earning income, managing risk and diversifying portfolios.
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