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.”
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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.