What You Need to Know
- Inflation is likely to rise, causing the Federal Reserve to raise interest rates, which is bad for bondholders.
- High-yield bonds are less sensitive to interest rate movements.
- Low-duration bonds' steady performance makes them attractive on a risk-adjusted basis.
Fixed income investors have enjoyed a stellar 40-year bull run that has produced a 7.52% annualized total return for the Bloomberg Barclays U.S. Aggregate index through March 2021, while falling 10-year Treasury yields have been the wind in the sails for bonds.
Yields on 10-year Treasury have been on a long and steady fall from 15.84% in 1981 to their all-time low of 0.52% in August 2020, which has boosted bonds and supported expanding equity multiples along the way. The stellar fixed income run, however, is under immense pressure as inflation could derail the 40-year trend of falling Treasury yields that has supported bonds.
Bonds, including corporates and Treasurys, have benefited from muted inflation and a continuous slide in Treasury yields, But those trends look to be on the verge of ending. Treasury yields look to be on their way to 2% after rising over 120 basis points since hitting August lows. Massive fiscal stimulus, stronger economic growth and inflation expectations have pushed Treasury yields higher.
The outlook for economic growth continues to rise north of 7% following the passage of the massive American Rescue Plan, ongoing accommodative monetary policies and a ramp-up in vaccinations. This is great news, particularly to holders of risky assets like stocks.
However, this macroeconomic backdrop may not be music to the ears of investors who rely on a steady stream of investment income. The strong economic growth is likely to boost inflation, eventually causing the Federal Reserve to raise interest rates, which is a bad combination for bondholders.
Due to years of declining yields, bond duration has increased and has become a real threat to prices — especially now, with the expectation that rising inflation will likely lead to higher interest rates.
Duration is a measure of the approximate price sensitivity of a bond to interest rate changes. Specifically, it is the approximate percentage change in price for a 100-basis-point change in interest rates. These higher interest rates will negatively affect bonds, particularly those that are more sensitive to interest rate movements (long duration).
Due to growing interest rate risk, the term “risk-free return” may not hold true; in fact, it may be more accurate to use Leon Cooperman’s wording, “return-free risk.” With this backdrop, the question is: Where do investors look to generate the required income while risk in historically low-risk assets has increased?
The first place to look is bonds with low duration, or sensitivity to interest rate moves. For example, if interest rates rise 1%, a bond with an average duration of five years would lose approximately 5% of its value.