Inflation, Duration and Frustration: Investing in a Risk-Filled Fixed-Income Climate

Art by Caroline Barlow

The U.S. equities market is fraught with concern over what may develop into a period of muted growth, lacking the largesse many investors became accustomed to during the stimulus-fueled expansion of the COVID-19 era.

A time-honored tradition for asset managers to mitigate concerns about high volatility in equities is to allocate more conservatively via a “barbell” strategy—moving resources away from the fluctuations of equities and toward the safe haven that Treasuries and corporate issuances offer in the fixed-income market.

Fixed-income investments, like all investments, carry various forms of risk, despite offering a coupon payment. The most prevalent risk today is rising interest rates, which spur existing issuances to reprice lower, but also create opportunity in shorter-duration products.

Outside of the risk of default and interest rate risk, a massive risk to fixed-income investing is inflation, as the value and buying power of an investor’s coupon payment erode when considering the real return of a fixed-income product.  

In the wake of massive stimulus packages passed to aid a stalled global economy, the world has seen elevated inflation. The July year-over-year inflation number for the U.S. economy was 8.5%. Year-over-year core inflation increased by 10.07% in Brazil, 10.1% in the U.K. and 6.3% in South Korea.

To quell the inflationary pressures domestically, the Federal Reserve has embarked on its first rate-hike cycle since 2017 and 2018. Recent comments from Fed Chairman Jerome Powell at the central bank’s annual Jackson Hole Summit reaffirmed that the Fed will keep raising rates in its effort to bring inflation back under control.

The Fed finds itself in a precarious position. After four rate hikes this year and the promise of more hikes to come, the U.S. carries a flat yield curve. The yield curve is also inverted at multiple points along the curve due to high levels of sovereign debt, keeping the 30-year bond range bound below 375 basis points.

For fixed-income products, this is a worst-case scenario. After struggling with reinvestment risk—the inability to reinvest into another fixed-income product at the same level of yield and risk at expiry—when rates were near zero, fixed income now faces duration risk, which is associated with the sensitivity in a fixed-income investment’s price to a change in interest rates.

Cleveland Federal Reserve President Loretta Meester said in August that she sees the federal funds rate rising to 4% in the coming months, significantly higher than the current 3.00% to 3.25% target range. With this forecast, the fed funds rate would likely eclipse the yield of a 30-year bond for the first time since 2007, while the two-year note could invert heavily against the 30-year bond.

Maria Vassalou, co-CIO of multi-asset solutions at Goldman Sachs Asset Management, forecasts a 3.5% fed funds rate in the coming months, noting, “monetary policy works with a lag, and it may take six months to even 12 months before we see the full effects of the monetary policy tightening on the real economy. Most likely, the rate increases we have seen thus far this year have not yet played out and worked their way through the real economy. We are likely to see a further slowdown in economic growth in the coming months.”

With geopolitical risks and supply-side disruptions driving inflation in 2022, Vassalou believes the neutral inflation rate in the medium-term may settle somewhere above 2%, perhaps closer to 2.5% or 2.75%.

With this target in mind, Vassalou says, a measured approach by policymakers would yield the best outcome for the economy.

“It may be prudent for the Fed to temporarily move its target inflation rate slightly higher to take into account these structural medium-term factors, rather than push to return it to 2%, risking undue demand destruction that can potentially be highly damaging to the real economy,” she says.

Mike Hunstad, CIO of global equities at Northern Trust Asset Management, echoes that view.

“We have a target of about 350 – 400 basis points on the federal funds rate, meaning there will be additional increases on the horizon. Though inflation will come down, it remains to be seen at what rate. The more the Fed clamps down with rate hikes, the more they risk a recession. We expect them to be calm and cool moving forward, so as to not spook the market.”  

Vassalou says there may still be opportunities in the space despite some of the duration risks facing fixed income. “One of the things we have done in our portfolio is to reduce exposure to credit markets and high-yield and moved up the quality spectrum toward Treasurys,” she says.

Vassalou gives a full breakdown of how to play this environment across the scope of fixed income. “We are less positive on emerging markets debt than on U.S. debt,” she says. “This time around, it is a very different case than during the financial crisis, when the European and U.S. markets were more affected by the fallout than emerging markets were. In this environment, elevated inflation is a global phenomenon, and the Federal Reserve’s monetary tightening has led to a much stronger U.S. dollar against most other currencies. As a result, emerging market debt does not look as attractive, especially in U.S. dollar terms.”

She adds that in domestic markets, “we think that the 10-year may offer again some value as the inflation rate peaks, monetary policy becomes restrictive and the yield curve inverts further.”

Vassalou also sees the corporate fixed-income market becoming tighter after issuances in the tens of billions by Amazon.com Inc. and Facebook parent Meta Platforms Inc. To investors this year, “there will be fewer issuances in the corporate market with rates going higher and the costs of capital increasing,” she says. “Depending on the quality of the corporation, its balance sheet and operational efficiency, there may still be some attractive names, but in general, there will be less supply, and the probability of defaults will increase as interest rates move higher.”

Hunstad, observing similar dynamics in the fixed-income market, sees an opportunity in high-yield corporate credit, saying, “clearly rising rates are on everyone’s mind, and thus we have seen a shortening up on duration, and you have seen a lot of inflows into ultra-short products.”

Hunstad adds, “There is little incentive to take on duration, for those who do not have an offsetting liability. Default probability remains low, and the opportunity is in the high-yield space, with there being a tremendous opportunity in the lower credit quality names. Their yield is dominated by credit ratings as opposed to movements in interest rates. As such, to take advantage of this environment, we have reduced our strategic exposure to investment-grade credit, making it the largest underweight in our global policy model, and moved the reduction to high yield, making it our largest overweight position, with the idea being that as you move away from investment-grade you limit your exposure to duration risk.”

The risks of fixed income investing, from reinvestment risk and inflationary risk to duration risk have affected the allocation of portfolios significantly over the past two years. “Many clients have reduced their fixed income exposure,” Hunstad says, “including many who have allocated towards high-quality equities with a lower risk profile, lower volatility, and a higher dividend yield, thus giving them the upside of equity market exposure without taking on oblique risks associated with duration facing fixed income. One area in which we have increased our tactical allocation to fixed income is inflation-linked bonds, as have many of our clients.”