Aside from the structural arguments, there are a number of fundamental factors that support allocating to bonds; the most important is the Fed acting decisively to ensure market stability and to support asset prices. In March, the Fed announced that it would directly purchase corporate bonds, including those that were subsequently downgraded to high yield. It also instituted a new facility that gives corporate borrowers direct access to the Fed balance sheet in the event the new-issue market closes again. It’s important to note that after these actions were taken, credit spreads became far less sensitive to changes in equity prices.
The Fed has been less aggressive in the muni market, but it provided a significant backstop when it established the Municipal Liquidity Fund. This fund, with $500 billion in lending capacity, is meant to ensure that even stressed issuers don’t see temporary COVID-19-related concerns develop into a more serious liquidity crisis.
In August, the Fed announced a major change to its inflation targeting methodology. Its new policy permits it the leeway to wait for significantly higher inflation before raising rates. With the year-over-year consumer price index only slightly off its 1.2% low, significant excess capacity in the economy, and fewer constraints, it’ll likely be years before the Fed moves policy rates higher.
Maximizing the income from the bond portion of a portfolio becomes more important on an incremental basis in a low rate environment. There are several ways to accomplish this, but it requires a trade-off. For instance, extending the maturity of a portfolio will increase its yield, but it will also increase the portfolio’s sensitivity to rate changes. A comprehensive interest rate scenario tool is a good way to assess this trade-off. For long municipals with embedded options, the trade-off is less about adding duration than it is about assuming extension risk—a trade that could make sense today.
Income can also be enhanced by investing in lower-quality bonds. A trusted team of experienced fundamental analysts can help advisors manage the trade-offs between higher yields and higher downgrade risks. Their principal protection ratings help guard against idiosyncratic risk by identifying issuers with a history of stable or improving ratings, avoiding the underperformance created by downgrades.
A proportionately weighted ladder structure maintained over time has a proven track record of increasing subsequent distribution yield and preserving principal. If rates rise sooner than expected, an investor could benefit from being in a well-structured ladder since maturing assets are systematically reinvested at higher rates. Additionally, in a rising rate environment, the ability to harvest tax losses can offset gains elsewhere in the portfolio. This provides investors with an additional benefit.
Bonds have a long history of providing important diversification benefits and incremental yield. Other than the historically low levels of yield, we see little to persuade us that those benefits won’t continue to accrue. Many of the same objections made against bonds today have been made in past. At the turn of the century, few investors thought that corporate bonds would outperform the S&P 500® over the next 20 years. From July 2000 to July 2020, corporates did exactly that—returning 6.31% versus 6.28% for the S&P 500® while suffering far less volatility. This shows that having a long-term plan and sticking to it are far more important than trying to time a major structural turn in market dynamics.