Bond investors need to keep interest-rate risk “at the forefront of their minds: If we have a meaningful move-up in rates, you could see negative returns in the bond market this year.”
That’s the crystal-clear warning from Jeffrey Sherman, deputy chief investment officer of DoubleLine Capital, helmed by Jeffrey Gundlach, who is CEO and CIO.
ThinkAdvisor held a wide-ranging interview with Sherman on Feb. 12.
He forecasts “a challenging year for fixed income investors” and urges particular caution in the corporate bond market, which likely has the highest interest-rate risk in history, he says.
With the U.S. economy poised to gradually return to healthy growth, Sherman anticipates rising interest rates.
That scenario won’t occur overnight, however: In view of the continuing weak labor market, America is “still mired in the recession,” he argues.
Sherman, DoubleLine’s lead portfolio manager for multi-sector and derivative-based strategies, was named one of “10 Fund Managers to Watch” by Money Management Executive magazine in 2018.
The chartered financial analyst hosts a popular interview podcast, “The Sherman Show.”
He joined DoubleLine in 2009 from TCW, where he focused on fixed income and real-asset portfolios.
In the interview, he discusses several good alternatives to bond investing this year: securitized assets, for example.
He also offers his broad picks in both the equity and bond sectors and unpacks the firm’s current strategy for the DoubleLine Core Fixed Income Fund.
ThinkAdvisor’s phone interview also revealed Sherman’s expectations for Janet Yellen as treasury secretary, as well as for Gary Gensler, President Joe Biden’s choice for SEC chairman.
Here are highlights of our conversation:
THINKADVISOR: What’s the most important thing advisors should know about fixed income this year?
JEFFREY SHERMAN: It’s going to be a challenging year for fixed income investors. The key is trying to manage the interest-rate risk: Where do interest rates go from here?
Rates have to be at the forefront of bond investors’ minds because yields are low, in general; spreads are tight. This means that if we have a meaningful move-up in rates, like 50 to 100 basis points, you could see negative returns in the bond market this year. It depends on the assets.
What approach should advisors use in talking with their clients about bonds?
Our advice to advisors is that you need to really think about the interest-rate component of [a] bond allocation. That’s the important thing at this stage of the cycle, as we talk about potentially more inflation or reinflating the economy; that is, getting back to things looking more normal-ish.
[But] if we have higher growth rates, that tends to lead to higher interest rates. The interest-rate piece is one of the bigger risks of markets today.
So, do you foresee rates rising in 2021?
Interest rates are likely to go higher this year as we reset back to a normalized growth environment. That means Treasury yields will go up, and there likely could be some negative returns in that area if they rise more than half a percent or so.
Please elaborate on your thoughts about inflation.
We think inflation is going to spike in the next couple of months, probably [to] 3%. Core inflation has been flat in the last couple of months. So the potential for inflation is there. It’s on a lot of investors’ minds; it’s on a lot of people’s lips. But it hasn’t come to fruition yet.
Once people think inflation will come, it can be very unwieldy because if you think prices are going up, and I think prices are going up and your neighbors think prices are going up, it creates the idea that you want to consume now before prices go up. So because everyone thinks inflation is coming, it can be a self-fulfilling prophecy.
What else should advisors keep in mind when recommending if clients should invest in bonds this year?
Typically bonds are owned as a risk offset; they’re in a portfolio to dampen volatility. So bonds were helpful last year in the downturn, especially Treasurys, in March. Today you have roughly more interest-rate risk in the corporate bond market than there has been historically.
As an advisor, you need to be cautious. What I don’t like is the high valuation of investment-grade corporate bonds. I don’t like taking significant amounts of interest-rate risk in the portfolios today.
Are there any good alternatives to owning bonds?
Yes. There are other things to buy that are exposed to the U.S. economy that have less interest-rate risk. For instance, you can buy bank loans. They, effectively, have no interest-rate risk; they’re tied to Libor [London Interbank Offered Rate] risk. They float with Libor.
That’s one way an advisor can say [to a client], “I recommend own[ing] some lower-risk assets; and maybe floating-rate loans make sense in this environment.”
Any other effective alternatives to bonds?
Securitized assets, like residential and commercial mortgages. Also, securities backed by student loans or franchise loans. There are a lot of different products out there that have exposure to the credit markets in the U.S. but have significantly less interest-rate risk.
And these securities have a higher yield than the corporate bond market, as well as about 20% to 30% of the duration of that bond market — so, a duration of two to three years. These are other ways to have exposure to the market and get what we think is a better yield profile with less interest-rate sensitivity.
Is the United States still in a recession?