The current narrative surrounding bond yields has been framed by a dovish Fed in one corner and inflation hawks in the other. How much more weakening of the belly of the curve will the Fed tolerate? Will material base effects on inflation prove transient or form a prolonged trend?
The majority of the performance from fixed income in the typical ‘60:40’ portfolio has been dominated by duration performance, with the 20Y Treasury Bonds returning 8.4% per year for the 10 years to the end of 2020, outperforming the higher risk, high yield corporate bond index by 1.6% per year.
After three decades of deflation we find ourselves in a period of increasing upward pressure on traditional inflation measures (as evidenced in the sustained rally in 5y5y inflation breakevens since March 2020) with obvious implications for yields. In this environment investors should not want a large allocation to long duration, conventional bonds in a balanced portfolio. But what about non-conventional bonds TIPS, High Yield Corporates / ETFs? Having the ‘right’ mix of bonds in the portfolio at the right time has historically added substantial value; this has been especially noticeable during the first quarter of 2021, where high yield bonds returned +0.44% whilst the 20-year Treasury fell -13.5%.
Despite the strong performance of duration over the past 10 years, as the relative chart below shows, there have been several opportunities to generate alpha by active asset allocation within the bond space. The chart also highlights the recent relative out-performance mentioned above. Will inflationary pressures continue this trend or will the FED step in, increase bond purchases, keeping yields low and altering the dynamic?
We held little conventional bond duration in the first quarter and for high risk mandates we held a profitable short position. As yields have risen so dramatically we have closed shorts and may look to add bond exposure in coming months. An active approach to both bond exposures and their composition is essential in this environment of very low yields and an unclear inflation outlook.