Bonds are suffering from a disconnect.
Real (after inflation) yields are negative. The Federal Reserve, through its Open Market activities, has kept bond yields lower than they likely would have otherwise been. And the Fed plans to "taper" these activities gently over the coming months, potentially allowing interest rates to find their natural, higher, level.
An environment of rising rates could easily result in negative returns for bond holders, as we saw in the first quarter of 2021, when Treasury yields rose 81bp and the average "core" bond fund lost 3%. While one needs to keep the magnitude of these losses in perspective (relative to stock market risk), if bonds are in the portfolio for "ballast" and diversification in bad times, and income generation during other periods, it might be hard for them to fulfill either role terribly well these days.
If the average short term bond fund yields less than 1%, it serves as a hiding place, and little more. And if those "core" funds, with 5+year average maturities, are much more exposed to rising rates, but are only yielding 1/4% more, then investors aren't being compensated for those risks.
Meanwhile, venturing into more aggressive bond funds, with exposures to junk rated debt, raises the average portfolio yield, but exposes the investor to the risk of far larger losses should the economy stumble, providing less diversification when they need it most.
Yes, this is a conundrum, but all is not lost.
Given the likelihood of higher marginal tax rates, municipal bonds still have a "wind at their back" to help mitigate price fluctuations from generally rising rates. We have seen this in practice in Q1 2021 when muni yields rose by less than half of the rise in Treasury yields. And foreign bonds have the potential to be priced on the fundamentals in the country of issuance, adding diversification to the factors that drive returns.
Investors may also have to be a bit more creative. If bonds are being held for volatility mitigation, shifting some of that allocation to liquid alternatives might make sense. Strategies such as "managed futures", multi-strategy (hedge fund-like) alternatives, and even buffered equity ETFs (where the price has a built-in floor and cap) could serve the same purpose. These are generally low return, low volatility strategies whose value might be seen in a period of rising rates.
And if income is the priority role for bonds, the investor may need to work both ends of the allocation. Shifting to more dividend oriented equities could provide an income uptick on part of the portfolio. Swapping bonds for fixed annuities can help with income generation on the more conservative side of the account. While annuities are cumbersome instruments (requiring paperwork to participate), their incorporation of two additional factors of insurance company management and mortality risk can raise yield versus traditional fixed income.
For investors who can invest in private securities, lending remains a lucrative business for private funds. Investors can participate in such vehicles with a small part of their portfolio, picking up 5-6% of incremental yield (with an increase in credit risk, of course.) Taken in moderation, this could be a good component of a yield enhancement program.
So, while investors in traditional fixed income have been well rewarded over the years, the likelihood of this continuing in 2021 is not high. A rethinking of the reasonswhy bonds are held at all can lead to the appropriate strategies for dealing with the current environment.