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The breakeven inflation rate is the difference between nominal yields and real yields. In early January, the entire U.S. Treasury breakeven inflation curve crossed above 2.0%. This has occurred less than 1% of the time in the past decade.
This event’s ramifications stretch beyond U.S. government bonds and now explicitly include corporate bond risk.
Why should you care about inflation risk on investment-grade credit? Because that sector makes up 12% of the industry’s dominant portfolio.
The traditional 60/40 portfolio is a “passive” mix of 60% U.S. equities and 40% U.S. nominal bonds. The benchmark that typically represents 40% of the 60/40 portfolio is the U.S. Aggregate Bond Index (the “Agg Index”). Using round numbers, the Agg Index’s weightings are 45% government, 30% corporate, and 25% mortgages.
By now, the low reward-to-risk setup of holding government securities is a consensus view. There is little room for yields to fall unless the Federal Reserve considers negative interest rates and no limit on how much they can rise. Add in the potential for a rise in inflation, and it is easier to understand why U.S. government securities could have a significant negative total return on both nominal and real interest rate bases.
But what about the much-less talked about 30% weighting of corporate bonds in the Agg Index?
Historically, investment-grade (I.G.) corporate bonds have provided a cushion for an unexpected inflation shock as spreads would tighten to offset higher interest rates. However, this is no longer the case because of tighter-than-normal credit spreads. Moreover, because of the low U.S. Treasury yields, the all-in yield of an I.G. bond portfolio offers much less offset than usual when interest rates rise. Finally, when inflation expectations are factored in, I.G. corporate bonds now have a negative real yield for the first time in history.
This inflection point arrives when duration risk is the highest in 20 years, and I.G. corporate credit spreads are near their all-time tight levels. This profile means that I.G. corporate bond returns are now very susceptible to even the slightest unexpected uptick in inflation.
Secondly, it is essential to understand this asset class’s recent evolution, which sometimes is overlooked given its lessor weighting to government securities in the benchmark.
Hopefully, by understanding this evolution vis a vis government bonds, the negative asymmetric return profile will be more readily apparent. This time, you can asset allocate your portfolio proactively.
When the Federal Reserve (the “Fed”) lowered U.S. interest rates to the Effective Lower Bound (ELB) in response to the pandemic, I.G. corporate bonds replaced U.S. Treasuries as the ballast in the 60/40 portfolio.
Simply put, the Fed’s reaction function changed. Alongside buying U.S. Treasuries and mortgages as part of its Quantitative Easing (“Q.E.”) program, the Fed began purchasing risky assets for the first time, including investment-grade credit. This new policy dynamic was announced on March 23, 2021. Not surprisingly, in retrospect, this marked the pandemic low for the S&P 500.
Finally, because of negative interest rates, it has been widely discussed that investors are paying foreign governments to lend them money. Over 40% of the world’s government bond markets have negative-yielding debt.
Now, this same phenomenon has extended to U.S. corporations. More than 25% of outstanding I.G. corporate bond issues are currently priced with a real yield below -0.50%. Said differently, one-fourth of IG-rated corporates are expected to be paid, on an inflation-adjusted basis, to borrow money today!
What Do You Do Now?
Adapting to rapid changes in the investment landscape has put dynamic asset allocation at the forefront of portfolio construction. Proof? It took 40 years for U.S. Treasuries to lose the accolade of “shock absorber.” I.G. corporate bonds only lasted 9-months as the replacement ballast in the 60/40 portfolio.
As the economy returns to full capacity, the risk of inflation increases. Thus, we believe investors must change their asset allocation to account for real interest rates instead of nominal outcomes.
U.S. Government and I.G. corporates should have minimal weight in a core fixed income strategy. Instead, investors should seek out active bond managers that combine the traditional benefits of a fixed income strategy with the advantages of non-traditional products.
We believe these managers have a greater chance of weathering potential inflation and reducing the erosion of purchasing power relative to off-the-shelf products.
