The bond market is in the midst of its longest and second-largest drawdown in the history of the index. But, there is a silver lining: bonds are now offering much higher yields. When yields started to rise in August 2020, virtually all Treasury bonds offered a yield of 1% or less; yields have more than tripled since then, offering significant opportunities for investors.
With this backdrop in mind, let's look at three strategies for taking advantage of the current environment, especially with Liquidity strategy assets that are earmarked for short-term spending in the next 3-5 years.
1. To help protect against a recession: A well-funded Liquidity strategy
It is always difficult to predict when a recession might happen. We don't expect a recession in the next 12-18 months, but the risk of a hard landing has increased. The 2-year / 10-year Treasury yield curve inverted in April, and the first estimate of Q1 US GDP showed negative real economic growth. With the Federal Reserve focused on fighting inflation, there is a risk that they will overcorrect and push the economy into a recession.
A Liquidity strategy can play a key role in helping you prepare for a recession. Historically, when we have seen a recession we tend to see stocks lose more than 20% of their value. The good news is that diversified portfolios have historically recovered from their bear market losses—registering fresh all-time highs—within 3-5 years of the previous market peak. By building a Liquidity strategy—and funding it with cash, bonds, and borrowing capacity to meet the next 3-5 years of your portfolio's cash flow needs—you can build a buffer between temporarily losses in your risk assets and the resources that you need to maintain your lifestyle. A Liquidity strategy allows the rest of your assets to remain invested for long-term growth.
2. To help protect against inflation: A commodity-linked structured investment
The Consumer Price Index registered an 8.5% year-over-year increase in March, the fastest pace of inflation since 1981. Although markets expect inflation to trend lower, Treasury Inflation Protected Securities indicate a breakeven inflation rate of 4.2% over the next two years and 3.2% over the next five years. If inflation is higher than these breakeven rates, TIPS will provide a higher return than nominal Treasuries because their bond values will increase with CPI, but there is a cost to this direct insulation against inflation: inflation fears have driven TIPS yields into negative territory.
As an alternative to investing in TIPS, we recommend that investors consider an allocation to a commodity-linked structured investment. Rising commodity prices are one major driver of inflation, but direct commodity investments come with equity-like volatility. In your Liquidity strategy, owning a commodity-linked structured investment with a 2-3 year maturity and full downside protection may help you to protect a portion of your spending against the risk of inflation. For more information, please see Structured investments: Commodities to help protect against inflation.
3. To take advantage of higher yields: A municipal bond ladder.
As we showed earlier, bonds have experienced losses not seen in 40 years. Although there is likely to be more rate volatility, we believe that the bulk of the rise in interest rates is behind us. In addition, higher bond yields will help to cushion investor returns from here and will help to bolster bonds' diversification benefits if stock market volatility continues.
For high income investors, municipal bonds appear particularly attractive in the current market, with taxable-equivalent yields that we haven't seen in over a decade. In your Liquidity strategy, we recommend investing a portion of your portfolio in a bond ladder with maturities that align with your personal cash flow needs. As the bonds in your bond ladder come due, you can move the proceeds into your checking account for spending. By matching your spending with specific bond maturities, you help to immunize yourself against further bond market losses; after all, the bonds are structured to mature at par in coordination with the timing of your spending needs.
For more, see the full report, Liquidity strategy: Guard against inflation, help protect against recession risk, and increase yield, published on 4 May 2022.
Main contributors: Daniel J. Scansaroli, Leslie Falconio, and Justin Waring.
This content is a product of the UBS Chief Investment Office.
Liquidity. Longevity. Legacy. framework disclaimer: Timeframes may vary. Strategies are subject to individual client goals, objectives, and suitability. This approach is not a promise or guarantee that wealth, or any financial results, can or will be achieved.