Jointly co-authored by our partners at YieldX
By all accounts, 2022 was a very challenging year for investors and fixed income has been no exception. The victim of more than a decade of loose (and, in some cases, extreme) monetary policy enacted by major central banks, the global bond market became highly vulnerable to rising interest rates after years of continuously falling yields and duration extension. These underlying dynamics reached an inflection point in 2022. The culmination of a global pandemic, supply chain constraints, and war in Ukraine drove inflation to 40-year highs and led to a hawkish pivot by central bankers that has resulted in sharply higher rates across the globe. Still, many investors may have been surprised to see just how deep in the red the fixed income portions of their portfolios were at a time when their equity assets were also in severe decline. This was supposed to be the ballast of their portfolios. As we head into 2023, inflation remains elevated despite the Federal Reserve raising its target rate four times by 0.75% and a fifth time by 0.50% last year. Does this mean more pain for bond investors, or is the worst behind us? In this discussion, we look to evaluate the opportunities in various segments of the fixed income market and ultimately answer a key question for advisors – does fixed income still deserve a place in their clients’ portfolios and are we entering the “New Abnormal”?
Government and municipal bonds provide a compelling opportunity
For risk-averse investors, U.S. Government securities (i.e., Treasurys and agencies) are offering their most attractive yields in over a decade and are backed by the full faith and credit of the U.S. government with little to no credit risk. The short end of the yield curve offers particularly attractive yields, with 1-year Treasury notes offering a yield of 4.6%, whereas long-term, 20- and 30-year Treasury bonds are only offering yields at 4.45% and 4.26% , respectively. High-quality municipal securities with similar credit risk offer tax-equivalent yields that easily top Treasurys. For example, a generic 1-year AAA-rated municipal bond currently offers a yield of 3.14%, which translates to a tax-equivalent yield (assuming a top tax rate of 40.8%) of approximately 5.32%. Compared to the start of 2022, when the yield on a 1-year Treasury note was 40 basis points (bps) and the yield on a 1-year AAA-rated municipal bond was 19 bps, the change in the income landscape is obvious. While investors should still consider the potential interest rate and reinvestment risk associated with future rate movements, the income now being offered by securities with little to no credit risk is quite compelling.1
Credit offers higher yields, mostly compensating for higher risk
Given how government rates set the floor for borrowing in an economy, the turbulent increases in benchmark yields have made an impact well beyond the U.S. Treasury space. While the Bloomberg US Treasury Index fell 14.3% in the first 10 months of 2022, other sectors have even poorer results. Mortgage-backed securities, a major component of the Bloomberg US Aggregate Bond Index and of the Federal Reserve’s shrinking balance sheet, have returned -14.9% over this same period as option-adjusted spreads on agency residential mortgage-backed securities (RMBS) widened. With its relatively long duration, the Bloomberg US Investment Grade Corporate Index has fared even worse, falling 19.6% as spreads have more than doubled since the start of the year. Despite representing a much riskier set of borrowers, the Bloomberg US High Yield Corporate Index shed less value than its investment-grade counterpart due to its relatively short duration, only falling 12.5%. Meanwhile, the Bloomberg US Aggregate Index, which incorporates all the investment grade sectors listed above and serves as the most prominent core fixed income benchmark, shed 15.7%.
Although this past year’s fixed income rout has been harrowing and many asset managers caution spreads may widen further, the flip side of these strikingly poor results is that forward-looking returns, roughly proxied by yield-to-worst, have become more attractive than they’ve been in the past decade. As highlighted in the table below, valuations have cheapened significantly across different segments of the fixed income markets. At current yield levels, barring an unexpected, dramatic move higher in interest rates, most sectors now provide attractive levels of income, which will be a larger component of total returns looking forward.
Despite 2022’s Fixed Income Rout, Most Sectors Now Providing Attractive Levels of Income
Portfolio construction is key to fixed income investing in the new “abnormal”
As the markets face the combination of high inflation, slower growth, and an inverted yield curve, how an investor determines the proper allocation between exposures to long- and short-duration opportunities across the credit spectrum is critical to achieving favorable outcomes. With short-duration securities across Treasury and investment grade credit providing real income, clients may want to consider implementing a hold-to-maturity strategy in some portion of their portfolio. This approach can lock in steady income and reduce the impact of interest rate volatility on a portfolio’s net asset value for the next few years.
Further, a keen focus on and adjustments to correlation expectations between dividend equities, high yield bonds (taxable and non-taxable), and long-duration treasuries would be appropriate. Whether executed by the advisor, or outsourced to a third-party money manager, modeling income versus risks in various outcome scenarios will be an important guide in navigating portfolios through this environment.
The bottom line is fixed income generates income
Returning to the broader question of what role fixed income has to play in investor portfolios, given the level of income now on offer alongside compelling valuations, we would say it is as key as ever. The most important factor to consider here is that fixed income once again actually generates income. This is not only beneficial to retirees and savers; it’s this income component that has historically provided bond investors with portfolio diversification benefits and downside protection when equity markets falter. In a new regime where the cost of capital has risen meaningfully and growth opportunities are likely to be more scarce, income, whether from bonds, dividend-paying stocks, or other interest- bearing securities, will be a key driver of market returns and should be an essential component of any well-diversified portfolio.
Special thanks to our partners at YieldX for their help on this piece. Visit yieldx.app to learn how YieldX is transforming the design and delivery of personalized income investing solutions at scale.
1 As of 10/26/2022