Amid Economic Recovery, How Stable Is the Bond Market?

Sonal Desai, the CIO and executive vice president of Franklin Templeton's fixed-income group, broke down the current bond market and offered her thoughts on the risks and rewards of low-yield bonds on Morningstar's The Long View podcast.

Forecasting a challenging future for bond returns, Desai addressed the current environment of historically low yields and stretched valuations. She also discussed how the coronavirus pandemic--and subsequent economic recovery--might affect future fiscal and monetary policy, especially considering rising inflation, snarled supply chains, and the current state of unemployment in the United States.

Here are a few excerpts on the efficacy of incorporating bonds into a retirement portfolio and bond funds' recent popularity from Desai's conversation with Morningstar's Christine Benz and Jeff Ptak:

What Role Do Bonds Play in a Retirement Portfolio?

Benz: Many advisors who listen to this podcast are trying to help their clients navigate retirement amid a vexing set of issues. What advice do you have for them, particularly when it comes to the role that low-yielding bonds might play in a portfolio?

Desai: There seems to be a general consensus that people need to be holding more equity in their portfolios. Certainly, this is an idea we're very cognizant of; rising life expectancies have changed how retirement works in an ongoing, forward-looking way. There is definitely room for more growth assets, such as equities, and yet there's also a greater need to ensure that enough assets are simultaneously invested in fixed income--to basically provide that ballast to the riskier assets. There is this consensus--which I actually don't disagree with--that perhaps today you need more equities, that the traditional 60/40 idea isn't necessarily the correct one to think about as you're looking forward to a future that will include a longer life span.

Income continues to be a core objective of retirement planning. This has not changed. So, a steady stream of distributions will be particularly valuable in a low-rate world. But I do think that it behooves retirees and potential retirees to broaden their investable universes beyond equities where appropriate, and to look into areas such as high yield where you can get outsize yields to supplement lower-yielding assets. Historically, high yield has always made people nervous because of riskiness, but the asset class has grown--both in size and quality--over the past few decades. So, I don't think we should still be looking at high yield or even emerging markets as fringe or nonretiree investments.

What Explains the Recent Growth in Bond Funds?

Ptak: Despite paltry yields, investors continued to pour money into bond funds over the trailing year through May 31, 2021. For instance, our data finds bond funds gathered nearly a trillion in net new dollars, which is really stunning. What in your view--you're very close to the action--explains this growth? Are demographics continuing to fuel the demand?

Desai: I think demographics certainly play some role, but I think we also need to look at this truly remarkable period we're in, where there is a lack of yield around the globe. So, you're not just looking at U.S. demographics here, you're looking at global demographics too, to some extent. I think global demographics do drive the continued flows into bond funds. The famous TINA [there is no alternative] comes into play. If we consider what central banks have been doing--not just this past year, but also in the post-global-financial-crisis period--the world has been flushed with liquidity. There is an enormous amount of liquidity. Central banks, certainly developed central banks, have been suppressing yields around the world. This means that investors keep getting pushed out on the risk spectrum and they end up being forced into longer duration, one way or the other, and to some extent, lower quality in the search for yield.

Other components that would have contributed to this trend are the recently adopted fiscal policies, combined with the fact that we had a significant increase in the savings rate over the course of the pandemic. There's a lot more money available to invest. So, I would say that on the demographic side, certainly, there is a continual need for income. As an enormous cohort--the baby boomers--enters retirement, there will be an increasing number of investors who are putting money into bond funds. There is also the fact that bond funds will always give you (or should always give you) less volatility; that's a desirable characteristic as well. All of these variables have contributed to the growth of flows into bond funds.

This article was adapted from an interview that aired on Morningstar's The Long View podcast. Listen to the full episode.