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Have you ever wished for the safety of bonds, but the return potential...
The economic consequences of government lockdown orders have had a profound impact on fixed income securities. After a highly volatile six months, investors are starting to adjust their fixed income portfolios to account for the “new normal” in the bond market.
Governments’ response to the Covid-19 pandemic cost the global stock market $16 trillion in less than a month. The selloff was so severe that the CBOE VIX – the U.S. stock market’s preferred volatility measure – exceeded levels last seen during the 2008 financial crisis.
A synchronized policy response from global central banks helped to reverse the decline. In the United States, the Federal Reserve reverted to zero-bound interest rates, added trillions to its balance sheet and broadened its money market liquidity support.
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Although the Fed’s policies over the years have contributed to a drastic fall in yields, they have also propped up the bond market through mass liquidity operations. The role of credit ETFs in providing liquidity has also played a role in aiding price discovery.
Roughly one week after cutting interest rates back to record lows, the Federal Reserve launched its corporate-bond facilities program on March 23, 2020. The program, which initially covered investment-grade bonds, later expanded to include ETF and junk bonds, boosting investor confidence.
The net effect was a significant improvement in liquidity conditions. Specifically, as MSCI notes, bid-ask spreads decreased, the dispersion of quoted prices declined rapidly, and dealers resumed quoting assets they had stopped bidding during the height of the crisis.
Check out the implications of growing government debt during the COVID-19 crisis here.
Fixed income securities proved their worth during the height of the market meltdown in February by providing “crash insurance against equities,” according to George Bory, managing director and head of fixed income strategy at Wells Fargo Asset Management. Bonds performed as advertised by offering a buffer against stock-market volatility.
Although fixed income is still viewed as an essential part of a well-balanced portfolio, it takes more bonds to offer the same diversification versus riskier assets, according to David Zee, a portfolio manager at Manulife Investment Management.
Fixed income is under increased scrutiny because of the drastic fall in real bond yields – a trend that long predates the 2020 liquidity crisis. With bond yields so low, and in fact below the level of inflation, investors are casting their nets wider to generate diversified sources of income. This partially explains the explosive growth of alternative investments since the 2008 financial crisis. Global alternative assets under management topped $10 trillion in June 2020 and are expected to exceed $14 trillion by 2023, according to Preqin.
With the Federal Reserve essentially committing to unlimited quantitative easing, investors can expect rates to stay very low for a long time. Interest rate volatility is also going to remain very low. This policy will likely lead investors back into riskier assets in pursuit of inflation-beating returns.
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Structural changes in the fixed income market are forcing investors to find alternative solutions. Here are some key points to consider while rebalancing your fixed income portfolio.
Regardless of the strategy you pursue, strategists are starting to agree that the traditional 60/40 investment portfolio is no longer sufficient. This portfolio is likely to lead to lower returns in the future as bond yields remain anchored near zero for many years.
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