So, how do investors get comfortable with owning fixed income given that ultra-low interest rates risk being pushed higher by rising inflation fears? Two considerations: First, the duration of the portfolio can be managed to balance mark-to-market risk with reinvestment potential at higher yields. Second, the portfolio can be diversified with alternatives to ultra-low yielding U.S. Treasuries, such as TIPS, or other higher income-producing investment-grade alternatives such as short-duration corporate bonds.
In the third edition of "Inside the Yield Book," the authors mathematically demonstrate that the cumulative returns generated by a bond portfolio will be higher in a rising-rate environment if the investor remains invested for at least twice that of the portfolio's duration (in years). The incremental accruals earned from the portfolio's rising yield offset the mark-to-market erosion over that time frame.
For example, assume a portfolio has a 2-year duration and a 1% yield today. In Scenario 1, rates remain unchanged during the next five years, equating roughly to 1% x 5 = 5% cumulative return (ignoring compounding for simplicity). In Scenario 2, rates rise by 1% a year for the next five years, equating to 2% in mark-to-market losses each year, but accruing progressively higher income of 2% + 3% + 4% + 5% + 6% = 20%. Subtract the accrued mark-to-market losses of 10% and the cumulative return is 10% — outpacing the unchanged rate scenario by 5 percentage points. Voila! Inflation can actually benefit the patient bond investor who reinvests into higher yields.
In addition, investment-grade alternatives to U.S. Treasuries can provide additional cushioning against inflation. If the current break-even inflation expectation for 5-year TIPS is 2.5%, then 5-year corporates with 100 basis points of additional spread will increase the inflation breakeven to 3.5%. CPI has not printed above 3% in almost 10 years, so that additional yield could mean the difference between a positive and negative real return if this low-interest-rate environment persists.
Naturally, if an investor strongly believes in the current inflation narrative, then TIPS, cash and shorter durations make sense. A sharp rise in interest rates could lead to price drops even for TIPS positions. However, those who are less sure about the change in inflation expectations from here may wish to tweak their bond positioning. Short-duration, income-producing corporates and securitized holdings such as commercial mortgage-backed securities and asset-backed securities can provide a yield cushion, while generating solid cash flow that can be reinvested at higher rates. Patience, reinvestment and understanding market expectations are the keys to staying ahead of an uncertain future.
Jake Remley is a senior portfolio manager at Income Research & Management in Boston. This content represents the views of the author. It was submitted and edited under Pensions & Investments guidelines but is not a product of P&I's editorial team.