Fixed Income Investing Needs Hands On Approach in 2021
OK, I know in advance I am going to bore some readers to tears with this topic. There is no way I know of to make a post on fixed income investing into a very compelling read! But most retirees or near retirees have a significant portion of their invested assets devoted to fixed income – even as few really understand much about fixed income investing. It is easy to make the assumption that what has been proven to work with stock investing (broad based, low cost index funds) is also the best approach to fixed income investing. But I believe this is a dangerous assumption to make in this crazy world of near 0 interest rates.
Before I begin I will acknowledge that investment pundits have been telling us for several years that bonds would be a terrible investment moving forward. Yields had fallen as far as they could go, they said. Since bond prices tend to fall when interest rates rise, and vice versa, there was literally no hope for bond investors. Or so they told us.
Then came the pandemic. The Federal Reserve started buying up anything that even looked like a bond, creating huge deep pocketed demand. This led to several outcomes. First, it drove bond prices up (and interest rates incredibly low). Second, it limited the risk of default on riskier bonds since companies could issue debt at low prices to fund themselves through the pandemic. Third, it caused all those pundits who said bond investing was dead to gorge themselves on crow sandwiches.
Bond investors ended up making money in 2020 no matter what bonds they owned. In that environment, a simple index fund can be an excellent investment. In fact, the Vanguard Total Bond Market Index in 2020 experienced a total return of 7.71% in 2020, its best performance in years.
Moving forward, however, life is unlikely to be so simple, and bond market risks are already making themselves clear. As government deficits soar to unprecedented levels, and clamoring for more government spending rises, interest rates and bond prices will likely come under attack from two directions. First, increased government borrowing increases the supply of Treasury bonds. As any first year economics student knows, when supply goes up and demand stays the same – prices will fall. Second, all of the fiscal stimulus being forced into the economy threatens to finally reignite inflation. When inflation rises, investors will demand higher interest rates – regardless of what the Federal Reserve tries to do. (the Federal Reserve only controls the shortest term interest rates through its policy actions). Higher rates again mean lower bond prices, and that pain will be most acutely felt where bond index funds are heavily concentrated – low yielding, longer term government bonds.
What this all means is that the hands off “buy the index” approach is unlikely to work as well in 2021 as it did in 2020. Why? Well, the bond market index is dominated by US Treasury bonds (about 60% of its makeup). And many of the bonds in the index are long term bonds which suffer the heaviest losses when interest rates rise. Lastly, an index approach includes hefty doses of poor quality corporate bonds (so-called “junk bonds”) which have been supported by the Fed’s pandemic response – but may suffer as that unprecedented governmental support wanes in the coming year.
We are already seeing this trend starting to play out. Compare the returns of the Vanguard Total Bond Market Index fund with returns of several of the more actively managed bond funds we own in our client portfolios. (returns provided by Morningstar)
Jan – June 2020
July – Dec 2020
Vanguard Total Bond Market Index ETF
DFA Investment Grade Bond
DFA Inflation Adjusted Bond
Templeton Global Bond Fund
These data support the premise that a more actively diversified strategy in fixed income is beneficial in this post-pandemic environment. For the first six months of the year, when fear was the dominant investment theme, the bond index fund outperformed 3 out of 4 of these fund managers. However, during the last six months of the year, the score was reversed. 3 out of 4 of these strategies outperformed the Index fund. And so far in 2021, all the fund managers are outperforming the index. Perhaps most interesting of all is the strong outperformance of Treasury Inflation Protected Securities. These are mostly US government bonds indexed to inflation. With the prices of these bonds rising, investors are sending a clear message through the markets that they are increasingly worried about inflation risk.
I increasingly believe the path of least resistance for interest rates is higher, rather than lower. And that spells bad news for passive bond investors who are sitting ducks in such an environment. To effectively invest in fixed income in this environment, one needs flexibility to concentrate investments in sectors less exposed to rising rates – shorter term bonds, mortgage bonds, and inflation adjusted bonds, as well as global bonds which could benefit from a declining dollar – all may offer opportunities.
Of course there is no free lunch! What drove the bond index performance to outperform in the first half of 2021 was fear over the contagion and unprecedented Federal Reserve bond purchases of bonds - both of which worked together to drive interest rates to record lows. If the world goes to hell in a handbasket again, the bond index will again likely to be the place to be.
Past performance does not predict future results, and fixed income investing also involves risks. The above funds are for illustrative purposes and are not a recommendation to buy or sell any particular investment.