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26 May 2021 | GSAM Connect

How Bond Investors May Benefit from Reflation

The hot topic in financial markets these days is reflation, or what some call the reflation trade. With monetary and fiscal policymakers determined to stimulate spending and boost output after the COVID-19 economic contraction, many investors are bracing for sustained economic growth and rising inflation.

In relatively little time, value sectors have come to life, commodity prices have jumped and bond yields have risen sharply. US consumer prices, meanwhile, rose in April at their fastest pace since 2008, according to the US Labor Department.

We’ve seen all this before, of course. Talk of reflation was topical after Donald Trump’s victory in the 2016 US Presidential election and even more so following the Global Financial Crisis. So what’s happening today? Is this a temporary phenomenon or a long term trend? Time will tell. Still, it’s certainly possible that the global economy is on the cusp of a more inflationary regime.

Here’s the good news: our fixed income team sees potential opportunity in the reflation trade. To start with, the sudden increase in bond yields has created new opportunity in core fixed income sectors. High quality intermediate-maturity “core” bonds have the potential to offer more attractive income prospects in light of higher starting yields (Exhibit 1). Bond investors may also benefit from roll-down in today’s market environment, a by-product higher yields and steeper yield curves.

Exhibit 1: Starting Yields Matter: Higher Yields Coincide with More Forward Return Potential

Source: Barclays Live. As of 4/30/2021. For illustrative purposes only.

Taking a balanced view and considering that reflation may be with us throughout 2021, we believe bond investors should resist any urge to abandon their core fixed income allocations, which offer important diversification of equity risk.

As a compliment to a core positon, investors may want to consider tactically adding exposure to areas of the market most likely to benefit from a reflationary environment.

Balancing Tradeoffs: Short Duration. For investors who cannot tolerate sudden drops in bond prices – reducing duration may be more palatable. Shorter duration multi-sector strategies offer an income advantage to compressed ultrashort bond yields at the front-end of the market, given that the US policy rate is likely to remain near zero through 2023. And, shorter duration strategies still offer a hedge against potential equity risk (though likely less than intermediate duration strategies in extreme risk-off scenarios). With additional fiscal stimulus and the increased pace of vaccine rollout, a sudden backup in intermediate and long term rates steepened credit curves and have generated greater “carry and roll” potential than existed a few months ago.

The Search for Income: Bank Loans. We believe bank loans benefit from attractive valuations given current supply/demand dynamics. Given the floating rate nature of bank loan coupons, the recent sell-off in rates has prompted inflows into the asset class. Bank loans historically have delivered stronger risk-adjusted returns relative to high yield debt and rank higher in a company’s capital structure.

Keeping it Real with TIPS. As the breakeven rate of inflation has jumped from its March 2020 lows, Treasury Inflation-Protected Securities (TIPS) have held their ground better than their US Treasury cousins. While TIPS may not offer the same diversification benefits of a multi-sector core bond strategy, they can serve as a potential compliment to such strategies and may help investors capitalize on unexpected shifts in rate and inflation regimes. But investors should be aware that TIPS would likely do poorly were current strong growth expectations to fade.

Regardless of the potential for continued rising rates and the emergence of reflationary pressures, we believe that high quality intermediate term bonds should continue to serve as the foundation for fixed income portfolios. Core bonds provide balance and diversification within multi-asset portfolios, helping to offset equity market volatility. In our opinion, there is a strong case to be made for owning high quality fixed income, as steeper yield curves and higher yields can increase future return potential.

And here’s one more thing to keep in mind: Should the economy unexpectedly lose momentum as the year goes on and risk assets falter, core bonds at current yields will still offer ample cushion for investors. In other words, more income now and potentially a better hedge later if the market is wrong about growth and inflation.

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About the Author

Ashish Shah

Ashish Shah

Co-Chief Investment Officer, Global Fixed Income, Goldman Sachs Asset Management
Matthew Wrzesniewsky

Matthew Wrzesniewsky

Fixed Income Strategist, Goldman Sachs Asset Management

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