Silver linings after the bond rout

Central banks’ more aggressive tightening to combat runaway inflation has pushed rates higher across the yield curve, forcing fixed income investors to seek areas less sensitive to interest rates.

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Sam Lau, portfolio manager with Los Angeles–based DoubleLine Capital, said investors should look to non-traditional sectors.

“When we’re thinking about what’s attractive in fixed income today, sectors that have less sensitivity to interest rate moves come to mind,” Lau said. 

Lau pointed to securitized credit, such as non-government-guaranteed mortgage-backed securities both in the residential and commercial space, as well as bank loans and collateralized loan obligations (CLOs). 

“These non-traditional sectors within fixed income markets share those characteristics of having a lower duration or interest rate sensitivity and relatively attractive yields when compared to their traditional sector counterparts,” he said.

Lau said portfolios that include securitized credit and floating rate assets like bank loans and CLOs can complement traditional fixed income holdings. “But you need to be able to manage that credit risk.”

It’s been a painful start to the year for bond investors, with aggregate bond indexes for the U.S. and Canada posting double-digit losses for the year to date.

Longer-duration bonds have outperformed for decades as rates trended down, but that’s changed as central banks embark on what’s expected to be a more aggressive monetary tightening path. The yield on the U.S. 10-year Treasury briefly topped 3% this week, and many investors are looking at shorter duration bonds for some protection.

The silver lining is that yield levels are starting to look a bit more attractive, Lau said, particularly in the aforementioned non-traditional sectors.

Those specialty sectors generally have higher yields and less rate risk than traditional bonds, and investors willing to move into BBB-rated bonds will also find higher yields. The same is true for non-investment-grade bonds, albeit with more risk.

“For those managers that have the wherewithal to step into below investment grade credit, there’s also opportunity to pick up even more yield as long as you have the ability to analyze those credits and understand what the potential risk these bonds may add to your overall portfolio,” he said.

Corporate and consumer balance sheets are relatively healthy, which should continue to support credit fundamentals in the near term, and the labour market is historically strong, he said. Rising yields have also made for a cheaper entry points to bonds.

“The flight to safety aspect of traditional sectors are still very important today and you need that allocation in your portfolio, but great volatility will persist,” said Lau. “We prefer to maintain a shorter duration at the portfolio level.”

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Maddie Johnson

Maddie is a freelance writer and editor who has been reporting for Advisor.ca since 2019.