If fixed income strategists are right, investors’ core fixed income portfolios could generate zero total returns in 2018. With median forecasts¹ calling for a rise in U.S. bond yields of approximately 50 basis points (bps), the resulting price loss of the Bloomberg Barclays U.S. Aggregate Index (Agg) would be approximately 3%. With yields on the Agg starting the year at 2.71%, price losses will more than fully offset income. In order to avoid the fate of the performance benchmark, we would advocate reducing interest rate risk, increasing credit risk or a combination of both.

Reducing Interest Rate Risk

The Federal Open Market Committee will likely hike interest rates three times in 2018. This need not necessarily lead to losses for bond holders, but any resurgence in inflation will. This logic stems from the fact that the Federal Reserve (Fed) can influence short-term interest rates, whereas the outlook for growth and inflation impact yields at the longer end of the curve. While much has been made about the implications of a flattening yield curve, one consequence is that investors receive only incrementally higher yields for extending maturity. Put another way, the implicit opportunity cost of reducing interest rate risk is diminished. In our view, one simple way for investors to potentially add value versus the Agg is to reduce interest rate risk by at least one year.

Accepting Credit Risk

Few can argue that U.S. investment-grade credit is “cheap,” but we recently highlighted a few positive catalysts that could result from U.S. tax reform. The primary reason why we would advocate increasing exposure to credit risk at the expense of Treasuries is that this approach increases income opportunities. If we accept that rates will likely rise and that economic growth can continue, then increasing exposure to credit can boost returns. In our view, while 90 bps² over Treasuries is below historical averages, we see few reasons why credit spreads should meaningfully deteriorate in the medium term. As such, investors should accept the opportunities that the market is providing for the time being.