How do you position bond portfolios for today’s market environment?

When inflation is low, and interest rates are falling, aggregate bond indexes can perform well. However, today’s bond market environment appears to be remarkably different than that of the past. The new mantra? Higher for longer. Higher interest rates and higher inflation for longer than most investors have considered. But is anyone doing anything about it?

Here’s the problem: Many investors don’t tend to focus too much on the bond positions in their portfolios. The notion is that index bond positions or static allocations are good enough, and the mantra is to set it and forget it. 60/40, 70/30, 30/70 type stock-to-bond allocation portfolios had become ubiquitous in the sleepy low inflation low-interest rate environment. During that era, aggregate bond indexes and static allocations were fine for investors. But how should an investor be positioned if inflation ends up being higher for longer, if the yield curve reverts to normal, or if yields amongst bonds are highly dissimilar? It is painfully clear that today’s bond market looks nothing like the last decade’s, so why are investors still holding the same basic bond exposures?

To better understand how to position portfolios for today’s bond market, there are two important factors: the inverted yield curve and yield differentials between different types of bonds.

1. A record inverted Treasury yield curve

An inverted yield curve occurs when short-term treasury bonds have higher yields than longer-term bonds. Typically, the treasury yield curve is upward-sloping, where longer-term bonds have higher yields than shorter-term bonds. There are several implications of the inverted Treasury yield curve:

• Short-term bonds have a higher expected return (yields) than longer-term bonds.
• Expectations are that the Fed will continue to raise rates, pushing short-term yields even higher.
• If an inverted yield curve is to revert to a more normal upward slope, longer-dated bonds must underperform shorter-dated bonds. This outcome seems plausible if we end up with inflation higher for longer.
• Aggregate bond indexes often focus on high-quality and longer-dated bonds, which may likely end up being poor positioning for the current environment. Maybe the opposite positioning of short-term and higher yielding bonds makes more sense.

2. Relative value and margin of safety

Do yields matter? Today (March 8, 2023), high-yield bonds yield about 8.4% as measured by the ICE BofA U.S. High Yield Index, while the 10-year treasury bond yield is 3.9%. Conversely, inflation is 6.4% (trailing 12 months as of January ‘23). If yields are a good approximation of long-term expected returns, high-yield bonds at least stand a chance of outperforming inflation. Secondly, if the yield curve is pressured upward, higher-yielding bonds have less duration than aggregate indexes. Thus they may provide an added margin of safety in the event of inflation higher for longer.

Takeaway

Static bond allocations implemented with basic bond indexes are ok for investors if inflation is low or if interest rates are falling. However, today’s bond market presents investors with a remarkably different environment than any time in the past 10+ years. The outlook for the bond market appears to be the exact opposite of that of which investors are used to or how they are positioned.

At Frontier, our strategies are not dogmatically stuck in index positions or shackled with basic static allocations. We believe in independent thinking and independent choice. Frontier’s forward-looking investment process accounts for these changes in the bond market environment. We can also choose from almost any mutual fund or ETF in implementing our strategies, further refining our ability to define our outcomes. Bond positioning may sound boring, but today it will likely significantly impact investors’ return for risk outcomes. So, what’s happening in your portfolio?