This blog, written in cooperation with our Portfolio Insights team, is the first in a series focused not just on fundamental analysis but also on where investor dollars have actually been directed. We believe that real-world investor positioning can often be as important in determining market direction as the fundamentals, and that many investors would benefit in understanding how their peers are positioned. Each blog will focus on a specific opportunity set; this one is on Fixed Income.

Given the modest back-up in yields over the last several months, many investors are wondering if, and how, the role of fixed income in a portfolio might change moving forward. Certainly, part of the answer lies in the macro-fundamental backdrop; but some will also lie in the flow of investor dollars. After all, the fundamentals matter little if there are no “buyers” of the story.

As things currently stand, the yield environment for high quality fixed income remains among the worst seen in at least a quarter century. As a result, investors looking for income may have to look elsewhere, either assuming credit risk – though spreads here have tightened considerably, too – or looking outside of the asset class to dividend paying stocks, certain real assets, or annuity-type products. Despite the lack of income, however, high quality bonds do still have a role to play in a portfolio: namely as ballast, or an “insurance policy” for the uncertainty on the horizon. While the vaccination program continues to gain steam and additional stimulus looks near guaranteed, both GDP and the labor market are still weak relative to 2019, and their recoveries are still fragile.

Moving through the year, however, this story looks set to change. As growth accelerates in the back half of 2021 and inflation starts to bubble higher on the back of fiscal stimulus and pent-up demand, monetary policy will have to respond in kind. The Fed, having promised to keep short rates effectively at zero for years to come, will likely instead taper bond purchases, allowing long-end yields to drift higher. This will cause the yield curve to continue to steepen, making duration less attractive and lower-quality assets more attractive.

In terms of actual investor positioning, our analyses show that investors are generally in sync with the fundamentals. Many continue to use fixed income primarily as ballast, with ongoing core bond inflows pushing core bond products to two-year highs in advisor portfolios. Interestingly, the global economic recovery hasn’t been enough to tempt them into corporate debt or high yield, which have seen net outflows year-to-date. Any yield or diversification concerns have instead benefitted equities, which now represent 62% in the average 60/40 portfolio, as well as cash and alternatives. Recently, as yield curves steepened more rapidly, flows into nontraditional bonds and bank loans have also turned positive; however, they remain only a tiny fraction of high-quality debt.

All told, investors worried about the short-term can take comfort in knowing that higher quality, higher duration bonds are still able to provide protection, though they should also recognize that if conditions continue to improve, the insurance will have been unnecessary; and those looking longer-term should shorten up duration and begin rotating down the credit spectrum. Specifically, we suggest finding bond managers that can be creative when necessary, with the ability to use sectors like asset-backed securities and global credit to navigate an environment that will continue to shift in the coming months.

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