BlackRock favours shorter bonds to hedge volatility, higher rates

INTEREST rates and inflation will stay higher for longer than markets are pricing, increasing the attraction of short-dated bonds relative to longer-term debt, according to BlackRock’s research arm.

With consumer-price gauges remaining above central banks’ targets, expectations of rate cuts this year are misplaced, said strategists led by Jean Boivin, who has an overweight stance on high-quality short-term debt. They expect both the Federal Reserve and the European Central Bank (ECB) to hike interest rates this week, they wrote in a note dated May 1.

“We like bonds for income even if we don’t expect them to offset risk-asset slides as much as they did in the past – or gain in price from falling yields,” the strategists said. “Policy rates used to fall quickly as an economic downturn struck, pushing yields lower – but we think sticky inflation makes that unlikely.”

That’s a break from the traditional playbook which saw investors gravitate to riskier assets to generate returns or buy bonds on the expectation that they’d appreciate in value. The strategists said they are staying away from longer-maturity bonds with a higher sensitivity to interest rates because of the potential for further losses there.

Unusually high volatility in bonds has also dimmed their appeal for traditional balanced portfolios that allocate 60 per cent to stocks and 40 per cent to bonds, according to a separate note from the firm’s strategists.

The Fed and the ECB meet this week to decide whether more monetary tightening is necessary after raising rates to the highest in around 15 years. These hiking campaigns to tame surging prices have hit bonds hard, though money markets are pricing the US central bank reversing course later this year by cutting rates.

“Central banks are unlikely to come to the rescue with rapid rate cuts in recessions they engineered to bring down inflation,” the strategists said. “Investors also will increasingly ask for more compensation to hold long-term government bonds – or term premium – amid high debt levels, rising supply and higher inflation.”

Higher yields available on bonds are a mixed blessing, with the margin for error also considerably higher, according to BlackRock, based on calculations of annualised returns between various asset allocation mixes.

The difference in returns between 60/40 and 20/80 portfolios has grown to as much as four times more than during the easy-money policy years that followed the financial crisis.

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“Portfolio returns will vary more widely going forward,” said Vivek Paul, who heads portfolio research at BlackRock Investment Institute. “Now the price of getting it wrong is greater, but so is the benefit of getting it right.” BLOOMBERG