Financial markets expect the Federal Reserve to raise interest rates six times this year to counter persistent inflation, and market pricing remains very fluid. In our view, it may be time for investors to consider fine-tuning their fixed-income allocation.
A look back at past hiking cycles suggests some corners of the bond market may react more favorably to tighter monetary policy than others. For example, the yield curve has typically flattened when the Fed hikes rates, with yields on shorter-maturity bonds rising faster than those on longer-maturities. Also, more credit-sensitive sectors of the fixed income market have typically rewarded investors with extra income and better total return potential relative to high quality US Treasuries.
Source: Goldman Sachs Asset Management, Morningstar. As of Dec. 31, 2021. Short Credit provided by Bloomberg 1-3Y Credit Index, 2Y Treasury provided by the Bloomberg US Treasury Bellwether Index, 10Y Treasury provided by the Bloomberg 10Y US Treasury Bellwether Index, US Aggregate provided by the Bloomberg US Aggregate Bond Index, Bank Loans provided by the Credit Suisse Leveraged Loan Index, HY Corporate provided by the Bloomberg US Corporate HY Index. The returns represent past performance. Past Performance does not guarantee future results, which may vary.
How investors may want to fine-tune their fixed income allocations as the Fed prepares to hike rates will vary depending on individual circumstances and risk tolerance. But there are areas of the fixed income universe that have historically done well during recent Federal Reserve hiking cycles. Here are a few ideas to consider:
Focus on Income Opportunities: Some “risk-seeking” fixed income sectors have done well in recent rising rate environments, as these economically sensitive assets tend to thrive when economic growth is strong. Credit in particular tends to do well when the Fed is tightening policy—especially bank loans, which have floating rates that adjust higher as interest rates rise. In addition to offering higher income potential, bank loans have also acted as a portfolio diversifier, with low correlation to other fixed income sectors and attractive risk-adjusted return potential.
Reduce Interest Rate Sensitivity: Investors who can’t stomach too much interest rate volatility may want to consider increasing exposure to short and ultrashort bonds. Within this category, we believe short-term credit may help manage against longer duration risk, especially if the bond market becomes volatile. And the additional income from shorter-dated credit will likely provide more attractive income potential than higher quality US Treasuries.
Stay the Course: Core bond exposure remains important even in a rising rate environment, as these high-quality fixed income assets can provide important ballast to a diversified portfolio. But with a favorable economic backdrop, investors may want to consider a “core plus” allocation that adds a sprinkling of higher-risk assets such as high yield credit to boost return potential. We think strong economic growth should support higher risk assets. But keep in mind that traditional core bonds have historically offered better downside risk management.