Fixed income perspective – from the Investment Advisory Group

Executive summary

• Bonds are enduring their worst performance on record, facing generationally high inflation readings and synchronized global central bank tightening.
• As core fixed income resets, bonds are now positioned to deliver portfolios better income and ballast during turbulent markets.
  
• Passive investors can take advantage of the highest short-dated bond yields in 15 years, with the 2-year Treasury yield above 4.2% for the first time since 2007.
  
• For active investors, employing a barbelled duration strategy appears compelling, combining the highest yields in the front end of the curve with the ballast we expect from longer-dated bonds in the event of further economic concerns. 
  

Putting fixed income in perspective

In 2022, U.S. core fixed income has failed to deliver upon its valuable diversification benefits versus riskier asset classes. The synchronized decline in stocks and bonds continues to create acute investor pain. The traditional inverse relationship between stock and bond performance has broken down in the face of global central banks’ efforts to tame inflation at all costs. Rapid interest rate hikes and quantitative tightening are pushing bond yields higher (i.e., prices lower), while concerns over the economic impact are disrupting equity performance. In short, there have been very few safe harbors from the storm.

Year-to-date, the Bloomberg US Aggregate Bond Index (Agg) and S&P 500 are down -14% and -21% respectively. Over the past 40 years, it has been very rare to see simultaneous drawdowns of this magnitude sustained for this long. The broad-based market repricing to account for generationally high inflation and a very hawkish Fed regime continues to be a volatile, uncomfortable process. However, there is now substantial relative value in high quality fixed income. While rising bond yields (i.e., falling prices) are painful, ironically, they create fertile ground for higher potential future returns. The sharp rise in U.S. yields have consequently put core fixed income in a far better position to deliver on two of its key properties: 1) a reliable income stream; 2) portfolio diversification. 

Our take

Bringing the income back to fixed income

Since the start of the year, U.S. Treasury yields have risen dramatically across the yield curve, particularly in the first five years where yields are hyper-sensitive to the Fed’s policy rate settings. In this segment of the curve, high quality yields are at their highest point in 15 years in response to the Fed’s rate hike plans. For example, 2-year U.S. Treasury yields have risen by 344 basis points (3.44%) to 4.17% from just 0.73% at the beginning of 2022. After a decade of historically low interest rates, portfolios can now access attractive income streams without taking on a great deal of interest rate or credit risk. 

For many years, the extreme low-rate environment fostered a mantra for equity investors, ‘There is no alternative’ (TINA). In other words, paltry yields boosted demand for equities as investors sought more productive outlets. Now, many investors finally have a compelling alternative to riskier choices. Higher rates are creating a significant opportunity for passive fixed income investors, especially those with maturities coming due or those sitting on cash reserves. Historically, bonds’ total returns have been closely tied to their income streams. Therefore, the longer-term return outlook for U.S. fixed income has improved dramatically in the wake of this year’s move.

One risk bonds face is the potential to underperform even the rate of inflation. With a starting yield now above 4% for the first time since 2009, fixed income investors now at least have a chance of gaining an edge over inflation. The Agg has a yield to worst of about 4.6% and is comprised mostly of U.S. Treasuries and high-quality mortgage-backed securities. For investors who have the risk appetite to invest in sectors such as investment grade corporate or municipal bonds, even higher taxable and tax-adjusted yields are available.

Over the past several years as issuers borrowed at historically low rates, average coupon rates declined. Therefore, the income component of bonds’ total return offered only a marginal offset to the rapidly rising rate environment. However, this tide has shifted. The magnitude of core fixed income’s recent drawdown combined with the significantly higher starting yield is creating a rosier performance outlook over the medium term.

To read the publication in its entirety, including charts and support, please select the "Download PDF" button, below.