Can fund selectors rely on fixed income as a diversification tool?

A rate hike could be the Fed's next move

Tom Eckett

US dollar inflation

Government bonds play a vital role in protecting portfolios during a textbook recession, however, the possibility of a ‘perfect landing’ in the US is forcing fund selectors to look at alternative defensive options.

Increasing exposure to fixed income has been one of the most popular trades over the past 18 months as investors rushed to capture the attractive yields on offer following the fastest rate hiking cycle in the Federal Reserve’s history.

According to data from ETFbook, fixed income ETFs in Europe alone saw a record $70bn inflows in 2023, outpacing the previous figure set in 2019, as investors positioned for a fall in rates.

However, the ‘bonds are back’ narrative has yet to come to fruition, largely thanks to a stubborn US economy that has continued to defy expectations despite the Fed funds rate rising to its highest level since the Global Financial Crisis.

The recent US inflation data has given some comfort after the Consumer Price Index (CPI) increased by its smallest amount since November 2021 in April at 3.4%.

However, Fed chair Jerome Powell’s hint that the central bank may be forced to keep rates stay higher-for-longer prior to the inflation announcement makes for a grim reading for bond investors.

“Given volatile data and policy uncertainty, we think long-term US Treasury yields can swing in either direction for now and stay neutral on a six- to 12-month tactical horizon,” Wei Li, global chief investment strategist at the BlackRock Investment Institute, warned.

“In the longer run, we think long-term yields will climb as investors demand more term premium, or compensation for the risk of holding bonds. With the US Treasury boosting borrowing, we see rising debt leading to term premium’s return.”

If the US avoids a recession and there is a pick-up in growth, the Fed could find itself in a position where its next move is an interest rate hike, a worst-case scenario.

This real possibility creates an asset allocation headache for fund selectors, many of which have been forced to ‘re-risk’ – increase exposure to US equities – this year due to strong company earnings across the board.

Are investors ready for a repeat of 2022 where bonds and equities were both hammered? The latest Bank of America (BofA) fund manager survey suggests no as respondents have reduced cash levels to the lowest in three years.

While fund selectors will position portfolios for all scenarios via appropriate diversification, fixed income continues to be a painful trade as yields threaten to rise even higher from current levels.

It remains a core diversification tool for ETF investors but other options, most notably within commodities, should be seriously considered at this point.

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