Post-election rate spike highlights bond investors’ quandary

Kathleen C. Gaffney,  Co-Director of Diversified Fixed Income

Boston  - The rapid move higher in interest rates following Donald Trump's election victory underscores the predicament that investors face by holding the "safest" bonds such as U.S. Treasurys.

In volatile markets like this, it makes sense to step back and consider the big picture. Many investors are reassessing their fixed-income portfolios and trying to determine where the risks and opportunities are.

The velocity of the move higher has surprised many investors, and the percentage gains in U.S. Treasury yields have been large. Essentially, 10-year yields have jumped to about 2.2% from all-time lows of 1.3% set in July of this year. But thanks to accommodative central bank policies and persistent deflation fears, yields are still very low by historical standards.

Of course, the question is whether we could be at an inflection point. Even before the election, rates had been moving higher on rising inflation expectations and an important shift in central bank policy. The path of least resistance has changed. Now, investors expect the Trump administration's policies could trigger economic growth and inflation.

My view is that the secular bull market in Treasury bonds is over and we have seen the lows in interest rates. It doesn't, however, mean we are moving up in one straight shot. We expect more volatility and choppy markets. We believe credit as a whole has become overvalued and there is more potential downside in prices there. Even with the move higher in Treasury yields, credit valuations haven't budged much and don't seem attractive. In other words, yields in credit-sensitive bonds have increased but credit spreads relative to Treasurys haven't moved that much.

At the same time, traditional bond exposures such as the Bloomberg Barclays U.S. Aggregate Bond Index have low yields and high duration risk. We believe it's a tough time to be a traditional benchmark manager right now, and a great time to have flexibility.

We don't question the value of traditional bonds from a hedging standpoint; rather that the return component of bonds will be lower or negative. A shift in perception of fixed income from "safe and return-generating" to "risky" will likely come with a substantial rise in volatility.

So what are investors to do? We believe they would be well served by embracing three strategies that admittedly aren't easy to follow:

• Using volatility to their advantage.
• Truly focusing on the long term.
• Viewing cash as an asset.

Bottom line:  We want to stay patient and nimble with cash and wait for opportunities to unfold. This is why flexibility in fixed income is so crucial.