Morningstar - Q2 2021 - 36

Spotlight: Role of Bonds

Bonds Still Have a Role
Despite current challenges, investors
shouldn't turn their backs on fixed income.

BOND Q+A

Jerry Kerns

With yields near all-time lows and low
expectations for future performance, is it time to
re-examine the role bonds play in portfolios?
For answers, we turned to the fixed-income team
charged with managing portfolios at
Morningstar Investment Management LLC, a
Registered Investment Advisor and Morningstar
subsidiary. Dominic Pappalardo, senior client
portfolio manager; Ricky Williamson, head of U.S.
outcomes-based strategies; and Hong Cheng,
portfolio manager, outcomes-based strategies,
answered our questions in mid-March.
Question: Today's interest rates are at unprecedented

low levels. How did we get here?

Answer: Interest rates in the U.S. have been
trending down for decades. Using the yield of the
10-year Treasury as a proxy for rates, the peak
levels were reached in the early 1980s at over 15%.
Rates rose to those historic levels for a variety
of reasons. One of the most impactful was rapidly
increasing inflation and the tight monetary
policy the Federal Reserve enacted to combat it.

and crisis events. Recent examples include
the global financial crisis in 2008 and the COVID-19
pandemic in 2020. Fed rate cuts helped push
the yield of the 10-year Treasury to historic lows in
2020 of around 0.5% and held it below 1%
for nearly the entire year as it rushed to provide
liquidity and stability to financial markets.
This trend of rates reaching historically low levels
is not unique to the United States. Central
banks in developed markets across the globe, such
as the European Central Bank and Bank of
Japan, have taken similar actions, allowing rates
in their markets to remain near 0%, or even
below 0%, during the last two decades.
In the last several months, we've seen the yield of
the 10-year Treasury rise from its historic lows.
This is the result of market participants believing
the Fed may tighten monetary policy sooner
than expected, as financial markets have stabilized
and inflation has begun to resurface and may
become more of a concern than liquidity.
Q: What is Morningstar Investment Management's

long-term outlook for fixed income?

A: Our long-term outlook for fixed income is
tempered by the current low-rate environment,
and we expect returns will likely be below
historical averages for some time.

Over the last four decades, inflation has been held
in check by a number of factors, including
technological innovation, globalization, commodity
price stabilization, and productivity gains, and
rates have declined. Given these benign inflation
levels, the Federal Reserve has been able to
maintain much looser monetary policy, providing
lower-cost capital intended to help spur economic
growth and development.

The two components of total return-price
appreciation and income-are both hindered by
the current rate environment. The ability
for prices to increase is limited as rates hover near
the zero bound, and income generation will
remain limited until yields move higher.

In addition, the Fed has used the loosening
of monetary policy as a tool to combat recessions

From a fundamental standpoint, we are generally
comfortable with the credit risk in corporate

36

Morningstar Q2 2021

bonds, both investment-grade and high yield, but
at current valuation levels, we are cautious.
Other sectors, such as mortgage-backed securities,
are benefiting from continued Fed support
initiatives, although much like credit assets,
they trade at questionable valuations. While rates
are low and yield spreads in non-Treasury
sectors are tight, we don't see an immediate risk
to either increasing substantially due
to quantitative easing and other Fed support
programs, but we will continue to update
our data-driven analysis because that view could
change quickly.
Q: How has this view affected fixed income's role
in Morningstar Investment Management's portfolios?

A: Our investment process is based on rigorous
valuation-driven analysis regardless of market
conditions. Our current analysis supports
the belief that returns on fixed-income assets will
be relatively low for the foreseeable future,
as there will likely be some increase in rates over
our forecasting period.

While fixed income may not be positioned to
be the best-performing asset class going forward,
we are still proponents of having exposure
in client portfolios where it aligns with clients'
risk profiles and objectives. We are very risk-aware
when constructing client portfolios and
will prioritize that factor regardless of market
conditions. In other words, we will not add
risk or excess volatility to a portfolio in an attempt
to offset lower yields.
Conversely, we have adjusted our expectations
as to what fixed-income return profiles might
look like and have updated our portfolio return and
income projections accordingly. Our decision
as to how much fixed income and which sectors
to have exposure to will always be driven
by our analytical, valuation-based research work.
Q: Have Morningstar Investment Management's
standard equity/fixed-income recommendations shifted
significantly in recent years?

A: It depends on the strategy. We have certain
sets of strategies that are closely tied to
blended benchmarks of equities and fixed income;
for example, a 60/40 portfolio. We have
other strategies whose mandates are less tied
Morningstar - Q2 2021

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