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Navigating the Fixed Income Market in the Current Environment

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.

Be sure to check our Fixed Income Channel to learn more about different ways to generate regular income.

Fed Injects Liquidity Into Fixed Income Market

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.

Implications for Investors

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.

Use the Dividend Screener to find the security that meet your investment criteria.

Potential Fixed Income Strategies for Investors

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.

  • On a tactical basis, investors may find value in spread products whose yields are higher than U.S. Treasury or other sovereign bonds. Structured products – prepackaged investments that include assets linked to interest and other derivatives – may also fit the bill.
  • Emerging market debt also offers diversification benefits for investors who are primarily exposed to U.S. dollar-based fixed income securities. This includes focusing on target regions that have demonstrated better fiscal responsibility. In today’s environment, this also includes debt from regions and sectors that are less dependent on energy and other primary commodities. There is strong reason to believe that peak oil demand could come sooner than many had previously expected.
  • One way to counter falling yields is to pair traditional bonds with holdings that have limited duration. According to Lord Abbett, a privately held investment company, blending short duration credit with a long-duration Treasury portfolio offers significant advantages in terms of total returns and flexibility. This advantage is likely to hold because credit spreads have not returned to pre-crisis levels. They also offer higher compensation compared with other risk factors.
  • Many of these strategies require investors to scrutinize high-yield debt. Rick Rieder, BlackRock’s chief investment officer of global fixed income, has referred to high yield as a “Frankenstein market” due to its size and liquidity. He maintains that the distinction between high-yield and investment grade matters less than the sector.

The Bottom Line

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.

Be sure to check out Dividend.com’s News section to keep track of the latest dividend-related investing news and strategies.

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Oct 29, 2020

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