The Exchange

Fixed Income: Out of the Frying Pan, Into the Fire

The Exchange

By Jeffrey Rosenberg

When monetary policy makers so badly misdiagnose a problem, it can only lead to trouble down the road. I bristle every time I hear a member of the Federal Reserve worry aloud about investors’ “reach for yield.” Investors are not reaching – they are being shoved.

Investors – the savers in the economy – are underrepresented in the Fed’s most unbalanced approach to balancing its dual objectives. Lost are the needs of the “forgotten men (and women).” Left to fend for themselves in a world of zero interest rates and openly inflationary global monetary policy, how can they protect their hard earned savings from these policies’ eventual confiscating result?

For 30 years, steadily falling interest rates and low inflation fostered a bull market for bonds that delivered investors average annual returns of 8% in diversified bond funds. As a result, many investors became comfortable and content with this strategy – reliably collecting the steady income and returns needed to work toward their long-term goals.

The 2008 financial crisis perpetuated a “flight to safety,” driving strong inflows into bonds and bond funds, as investors reallocated away from equity risk to perceived safety. And since that time, despite double digit returns in equities, bonds delivered decent enough returns (averaging 6% since 2008) to keep up the demand for fixed income.

The reality is that the forces which once supported the bull market in bonds no longer exist. Going forward, “safe haven” fixed income investments likely will deliver neither income nor security. Investors should realize that what worked in the past won’t work in the future. It’s time to rethink fixed income and to consider new ways to generate returns from these investments.

In the current environment, low yields from unprecedented global monetary policy measures trap fixed income investors and lead them to greater susceptibility to higher interest rates. The 30-year bond bull market appears to have largely run its course: today’s Treasury offers a nominal yield of just around 2 percent, while broader investment grade markets as measured by the Barclays US Aggregate index of investment grade bonds (the “Agg”) offer no better yields. This means that in order for Treasuries or bond funds tied to the Agg to earn positive real income, annual inflation must remain below those levels far into the future.

The reality is that monetary policy is headed in the other direction. In pursuit of growth and higher employment levels, the Federal Reserve – as well as its global counterparts – are reaching for every implement in the toolbox to keep inflation above two percent. If these central banks are successful, investors would be locked into negative yields for years to come.

At least these investments are safe ways to protect principal, right? Not exactly. These low yield investments carry significant interest rate risk. While the Federal Reserve’s promises to keep rates low lead to market expectations for a zero interest rate policy to be in place well through 2015, unless these policies fail to restore economic growth, the Federal Reserve will have to increase interest rates. Because these bonds carry low yields, today a mere 0.20 percent increase in interest rates would be enough to wipe out nearly a year’s worth of income for the 10-year Treasury. A 0.30 percent increase in the Agg’s yield would do the same to investment-grade bonds. Worse still, even greater moves in interest rates would eat into investor principal.

In short, investors seeking refuge from uncertain yields and volatile markets in safe-haven bonds may be jumping out of the proverbial frying pan – and right into the fire.

Investors who want to stay in fixed income should start by thinking about casting a wider net. High-yield corporate bonds, emerging market debt and municipal bonds can all be targets of opportunity in the search for income at attractive levels, not to mention areas such as opportunistic credit, real estate debt, and high-yielding bank loans. Today’s markets are unlike anything we’ve seen before, with uncorrelated assets harder to find– meaning true safety is to be found in a more dynamic, diverse portfolio. So investors may also consider investing in flexible bond funds. Through dynamic asset allocation across a wider array of fixed income investments, flexible duration targets and risk mitigation strategies, these funds offer attractive income and greater stability of returns.

The global financial crisis and the global monetary policy response to it changed the world of investing dramatically and most notably that of fixed income. Investing strategies that worked well in the past won’t work in this new world of investing. Investors looking for safety and income will need to pursue a different course, one that entails a broader array of investments and a broader set of tools to achieve the elusive goal of a risk free return in a world where risk free investing offers only the guarantee of losing money.

Jeffrey Rosenberg, Managing Director, is BlackRock's Chief Investment Strategist for Fixed Income. His responsibilities include working closely with the Chief Investment Officer of Fixed Income, fundamental portfolios and team to develop BlackRock's strategic and tactical views on sector allocation within fixed income, currencies and commodities.

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