Investors Urged to Rethink Bond Strategies in Changing Market

In a recent episode of The Long View, Eric Jacobson, the senior principal for fixed-income strategies at Morningstar, discussed the evolving landscape of the bond market and highlighted the challenges investors face in navigating it. Jacobson’s insights, shared with host Dan Lefkovitz, underscored why many investors were caught off guard by the bond market’s volatility in 2022.

Central to the discussion was the notion that many investors are attempting to take a tactical approach to fixed-income investing, frequently shifting between cash and bonds in response to interest rate forecasts. Jacobson noted that this strategy often fails, as investor return data indicates that timing purchases and sales effectively is exceptionally challenging. He emphasized that, historically, betting against interest rates has proven risky, with only a handful of managers achieving consistent success, including the renowned investor Bill Gross from Pimco.

Challenges in Tactical Bond Investing

Jacobson pointed out that the bond market dynamics are influenced by a variety of factors, which makes it difficult to predict interest rate movements. He explained that during the 1980s and early 1990s, when interest rates were at extreme highs, investors felt more confident in making tactical bets. However, as institutional investors recognized the risks associated with such strategies, they began to shift their focus.

“The payoff isn’t good enough on the upside and it can be really bad on the downside,” Jacobson remarked. He urged investors to align their fixed-income positions with their long-term spending goals rather than attempting to time the market.

The discussion then turned to the bond market’s performance in 2022. Jacobson noted that the year was particularly tumultuous due to rising yields, as the Federal Reserve and other central banks reacted to inflation by increasing interest rates. Many investors failed to anticipate the rapid changes, which were compounded by the effects of the COVID-19 pandemic.

Understanding the 2022 Bond Market Meltdown

Reflecting on the events of 2022, Jacobson explained that while it may seem clear in hindsight, predicting bond market fluctuations is inherently complex. He highlighted how structural factors, such as government indebtedness and low interest rates, can persist longer than anticipated.

“After the financial crisis, there were predictions of rising interest rates that never materialized for over a decade,” he stated. “Investors who positioned their portfolios for a quick uptick in rates missed significant opportunities.”

Lefkovitz asked Jacobson whether adopting a passive strategy in fixed income could be considered a mistake. Jacobson responded that passive investing is not inherently flawed, particularly for those seeking core exposure to high-quality bonds, such as government securities or corporate bonds. He noted that low-cost index funds can provide valuable access to these markets without excessive fees.

Nevertheless, he cautioned that passive strategies could exclude various investment opportunities, such as collateralized loan obligations (CLOs) and non-agency mortgages, which have gained traction among active managers in recent years. Jacobson emphasized the importance of understanding the evolving bond market and the potential risks associated with passive investing.

As the bond market continues to adapt to new economic realities, investors are encouraged to reassess their strategies, focusing on long-term goals rather than short-term market timing. Jacobson’s insights serve as a reminder of the complexities inherent in fixed-income investing and the need for careful consideration in an ever-changing financial landscape.