by Neil Azous, Chief Investment Officer
- Case for Increasing “High-Grade” Fixed Income
- Case for Decreasing Treasury-Inflation Protected Securities (TIPS)
- Asset Allocation Changes
In our January 14th, 2021 investment commentary – Concerned About Inflation? U.S. Government Bonds Are Not The Only Asset Class At Risk – we highlighted that investors should have minimal weight in a core fixed income strategy to US investment-grade (I.G.) corporate bonds.
That asset allocation decision proved prescient and resulted in our fixed income strategies significantly outperforming. In the first quarter of 2021, the primary benchmark for US investment-grade corporate bonds fell -6.44% peak-to-trough. Historically, the average annual drawdown for the IBoxx US Liquid Investment Grade Index (IBOXIG) is less than 4%. Outside of systemic events – 2020 pandemic and 2008 Global Financial Crisis – this was one of the most significant drawdowns in history for this asset class. To further highlight the investor retreat from this asset class, in the first quarter, holdings of the largest investment-grade fixed income ETF (symbol: LQD) were reduced by 22%.
Case for Increasing “High-Grade” Fixed Income
Today, we are updating our asset allocation view. Our investment model no longer indicates that a core bond strategy warrants substantial underweight to “high-grade” fixed income, specifically municipals, investment-grade credit, and mortgages.
An often missed part of fixed income investing is capturing the positive rolldown when the US Treasury yield curve is steep. Even though yields can, and do, rise over the periods when the curve is steep, the total return can remain positive if the yield does not rise to the same degree that is discounted in the forward market. Said differently, even if yields rise, you are being compensated with a larger-than-normal risk premium. We believe this is one of those times.
Currently, the US Treasury forward yield curve is very steep, especially the intermediate portion. It reflects the expectation that the Federal Reserve will begin raising interest rates at some point over the next 18 to 24 months and begin a proper tightening cycle, raising short-term interest rates to at least 2%.
As an example of how steep the yield curve is currently, below is a table of the breakeven level of interest rates for US Treasuries to not have a negative total return by the end of the year. We think the amount of “cushion” a bondholder has now may surprise you.
The potential total return upside, not just the “cushion,” is also noteworthy. The median 2021 forecast for the 10-year US Treasury yield is 1.83% versus today’s rate of 1.61%. If this consensus year-end target were to materialize, while the yield is higher than today, the total return for an owner of 10-year US Treasuries, assuming it was rolled every month to keep the duration constant, would be approximately 2.9%.
Case for Decreasing Treasury-Inflation Protected Securities (TIPS)
Investors are overweight Treasury-Inflation Protected Securities (TIPS). This overweight has been warranted. The outperformance of TIPS relative to a similar duration Treasury has averaged between 2% and 5% throughout 2021. However, for the most part, the absolute return for TIPS has been negative.
The 5-year US Treasury inflation breakeven rate has risen from 1.93% at the beginning of the year to 2.65% currently, which places it in the 1st percentile of weekly readings on record.
The key point here is that while the principal protection from upcoming CPI releases will remain robust, the relative safety that is offered has dropped.
Asset Allocation Changes
To be clear, we do not have a bullish view on fixed income. The following are step changes, not significant allocation shifts. We do not think that interest rates will fall – we think they can and will rise. However, there is the potential that they rise less than expected, or take longer to rise.
In this spirit, we advocate two asset allocation changes. To quantify our changes, we use a scale of 1-10, with 1 being the most underweight and 10 being the most overweight.
Increase “High-Grade” Fixed Income: If your current fixed income weighting is skewed towards the most underweight possible (i.e., 1-2), we believe this should be raised to a level of between 3 and 4. Based on the amount of risk premium in the forward yield curve, even if the Federal Reserve were to begin an interest rate hiking cycle in the fourth quarter of 2022 and it lasts two full years (i.e., reach a peak Federal funds rate of 2.5%), the total return on a portfolio of high-grade bonds would likely still be positive.
Decrease Treasury-Inflation Protected Securities (TIPS): If your current fixed income weighting is skewed towards the most overweight possible (i.e., 9-10), we believe this should be reduced to a level of between 7 and 8. The overweight position in TIPS remains warranted due to the potential for relative outperformance, but we believe it should be pared back incrementally into the relative strength that has occurred this year.
As a boutique firm, we can help you navigate these potential critical changes in the market by providing direct access to our investment professionals and library of tools. At Rareview Capital, our goal is to become a trusted resource and the first call for your questions. Please call us at 212-475-8664 or email us at firstname.lastname@example.org.
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