By Timothy J. Videnka, CFA, CFP®
“People and nations do behave wisely once they have exhausted all other alternatives.”
For much of the past decade, investors had a fairly straightforward reason to take more risks: they weren’t being paid much not to. Prior to 2022, with short-term interest rates at or near zero, earning a reasonable return often meant owning more stocks, extending further out on the yield curve, accepting additional credit risk – including in areas such as private credit – or some combination thereof.
Today, that tradeoff looks very different. Short- and intermediate-term bonds are once again providing meaningful yields, while investors are receiving relatively little additional income for committing their money to much longer maturities. That matters because we believe every part of a client’s asset allocation should have a purpose. If the role of shorter-term bonds is to provide income, preserve capital, and serve as a reliable source of liquidity when needed, there is little reason to ask that portion of the portfolio to take risks it doesn’t need to take.
It all comes back to one of the simplest questions we ask when investing: What are we being paid to own relative to the risk we are being asked to take? Right now, we believe that tradeoff looks considerably more attractive in the shorter portion of the yield curve.
Mind the Slope: Inflation Expectations Have an Alibi
Recently, long-term interest rates have been rising. Not only here at home but globally. In fact, 30-year government bond yields in several major economies have recently reached levels not seen in many years. The natural conclusion might be that bond investors are becoming increasingly worried about inflation; the data, however, tells a different story.
Market-based measures of expected inflation have remained relatively stable. TIPS breakeven rates – the difference between the yield on a nominal Treasury and an inflation-protected Treasury of comparable maturity – have been relatively well behaved. In the NDR chart below, five-, seven-, 10- and 30-year break-evens were trading around 2.4%. In other words, the bond market does not appear to be telling us that long-term inflation expectations are becoming unanchored.
If inflation expectations aren’t driving long-term yields higher, what is? Increasingly, the answer appears to be rising real interest rates, a higher term premium, and an enormous amount of bond supply. Thirty-year TIPS yields – a measure of long-term real interest rates and a proxy for economic growth – recently moved above 3%. At the same time, the term premium, essentially the additional compensation investors demand for committing their money for longer periods, has been moving higher as well.
Higher long-term rates don’t necessarily mean the market expects higher inflation. Sometimes investors are simply demanding to be paid more to lend money for a very long time.
Econ 101: Someone Has to Buy This Stuff
Bond prices, like most prices, eventually come down to supply and demand. And there is an awful lot of supply. The massive buildout of artificial intelligence infrastructure has helped push corporate bond issuance to an average of approximately $34 billion per week, a pace exceeded only during the pandemic era. And that doesn’t include the additional financing occurring through loans, structured products, and private credit. Governments are adding to the supply as well. The United States, Japan and Germany all face substantial fiscal financing needs. In the U.S. in particular, large federal budget deficits aren’t projected to disappear anytime soon. See CBO (Congressional Budget Office) projections in the NDR chart below.
Someone ultimately has to buy all of that debt. And investors generally don’t absorb an ever-growing supply of long-term bonds out of the goodness of their hearts – they need to be compensated for it. That compensation can come in the form of higher yields which, of course, means lower bond prices.
Washington, the Bond Market Is on Line One
There is another side to all of this supply. The bond market has a way of imposing discipline when politicians won’t – or, perhaps more accurately, when the political system makes that discipline hard to come by. Meaningful deficit reduction eventually requires confronting some politically difficult choices. Running for office on a platform of cutting entitlements isn’t exactly a proven election-winning strategy. Politicians understand that arithmetic, which helps explain why difficult fiscal decisions are so often postponed.
The bond market, however, doesn’t run for elected office. Governments can run large deficits for a long time but, eventually, investors may demand higher yields to absorb an ever-growing supply of debt. If that happens in a meaningful way – what is sometimes referred to as the bond market “rioting” – higher government borrowing costs can force policymakers to confront choices they would otherwise prefer to avoid. The ballot box doesn’t always provide politicians with much incentive to make painful fiscal decisions. The bond market, however, can provide a different kind of incentive. It doesn’t get a vote, but it can still have the last word.
Bonds: Leave the Excitement to Stocks
At Forza, we tend to think about bonds within the context of their purpose within the entire portfolio rather than as an asset class that needs to generate the highest possible return on its own. In most client portfolios, the bond allocation has a very specific job: to fund liquidity needs. Whether that means providing for portfolio withdrawals, upcoming distributions or simply creating a reservoir of capital that allows us to avoid selling stocks at an inopportune time, the objective is straightforward: If we expect to need the money, we’d like to have a good idea where it’s going to be when we need it.
That makes credit quality and liquidity particularly important. Reaching for a little additional yield by accepting materially more credit risk or owning something that may be difficult to sell defeats much of the purpose of this part of the portfolio. A security advertised as providing “bond-like” income isn’t terribly useful as a source of liquidity if its value falls substantially at the same time as stocks, or if getting our money back requires waiting for someone else to provide us an exit. Liquidity is most valuable precisely when everyone else wants it, too.
The current interest-rate environment makes that tradeoff particularly attractive. Short-term bonds are offering meaningful income without requiring us to extend maturities significantly or reach down the credit-quality spectrum. For us, that means we can accomplish several things at once: earn reasonable income, maintain high credit quality, preserve liquidity, reduce interest-rate sensitivity, and retain the flexibility to reinvest as opportunities change. That’s not particularly exciting – and that’s the point.
When we know what an asset is supposed to accomplish within a portfolio, we don’t need to ask it to do something else simply because another few basis points of yield are available. Short-term bonds have a job to do: preserve capital and, most importantly, be there when we need them. We’ll leave the excitement to the stocks.