Video Transcript
The bond market looks a lot different today than it did a year ago.
Given the pace and magnitude of rate hikes, we are now seeing renewed demand for yield and diversification. While each client requires a unique approach to asset allocation, we have a few observations given today’s environment.
The ongoing rate hike cycle has significantly influenced investors' approach to analyzing risk-reward trade-offs. Notably, we have had an inverted yield curve for quite some time, with rates on short-term securities generating higher yields than longer-term bonds, which is contrary to the typical relationship observed among bonds of varying maturity dates.
In the municipal bond market, we’re seeing similar trends. A major flow of bonds into the marketplace in the second quarter, combined with outflows and FDIC liquidations, are keeping yields higher on the short end of the curve. Short-term investment-grade municipals are providing an attractive yield from a historical perspective with little credit or interest rate risk. However, it's also important to prepare for the long term and build a portfolio with various maturities to maintain cash flows.
Investors wanting to take on incremental risk may look to the corporate bond market. With higher yields we have seen a return of interest in core-bond strategies which historically have served as the ballast of a diversified portfolio. Both investment-grade and high yield corporate bonds provide a yield spread above respective Treasuries, but at the same time, these markets are not offering an exceptional spread to compensate for risk. Thus, selectivity in credit is warranted.
One strategy is a buy-and-hold “laddered” approach to portfolio construction, which helps manage interest-rate risk and takes advantage of today’s higher coupons across the maturity spectrum, with the added benefit of after-tax income potential.
On the alternatives front, we have seen the private debt industry meaningfully grow and evolve over the past decade. Private debt strategies such as direct lending and multi-strategy solutions may provide an enhanced and differentiated return profile as well as a means to diversify credit exposures.
The types of strategies that exist also can vary widely in objectives and characteristics. For example, a senior debt-focused direct lending strategy might serve a quite different role in a portfolio than a distressed credit strategy. That said, these vehicles also come with a unique set of risks and lack of liquidity—items to carefully consider when building portfolios.
The change we went through in the last year and a half offers a better yield risk/return proposition for investors. This impact has also influenced our forward-looking capital market expectations, which look out over 10-to 20-year periods. Fixed income yields have started to contribute to portfolio return expectations once again, whereas over the past decade low rates had relegated bonds almost solely to the role of portfolio diversifier.
Analysts cite the Fed's monetary policy and economic conditions as significant drivers of the bond market going forward. Of course, timing the Fed or the market is always challenging, therefore we think investors are best served by aligning their investments in bonds with their time horizons and investment objectives—one that is diversified and includes both equity exposure for growth, and bonds for diversification.
And of course, ongoing communication with your William Blair advisor is crucial in navigating today’s dynamic market environment.