Fixed income perspective – from the Investment Advisory Group

The 10-year U.S. Treasury yield is compelling above 4%

• In Part I, we discussed using a high quality passive approach to maximizing income in a shorter dated portfolio. In Part II, we highlighted the increased value of duration (i.e. a measure of price sensitivity to a change in interest rates) in light of last year’s rising yield environment and growing economic concerns. A barbelled portfolio combines these two strategies.
  
• A barbelled portfolio combines shorter and longer duration fixed income to achieve a desired overall portfolio duration. How each end of the barbell is weighted determines the overall duration structure – short, neutral or long versus the benchmark.
• Currently, a barbelled portfolio can capture the curve’s highest yields in the 0-3 year maturity range while establishing longer duration exposure that should generate positive total returns in the event of economic deterioration.
• Our work suggests that longer duration and higher quality fixed income each tend to outperform shorter-dated debt and lower-rated bonds as the economy slows or enters a recession. Currently, our weakening economic outlook supports an aggregate portfolio duration beyond neutral.
• We recommend emphasizing high quality fixed income in the very near term, such as U.S. government debt and investment grade municipal bonds. We expect riskier sectors and those with higher correlations to U.S. equities (high yield corporates, convertibles, leveraged loans) to face challenges in the year ahead.
• An important consideration: the Fed’s balance sheet reductions are creating elevated volatility and lower liquidity. As such, we anticipate outsized day-to-day yield swings to continue. Longer duration fixed income yields will likely face bursts of strong moves in both directions in reaction to new data and potential shifts in Fed policy. However, the shorter duration component of a barbelled portfolio should help dampen overall portfolio fluctuations.
• We expect a wide trading range as a result of elevated volatility and economic uncertainty. For investors trading the longer end of the barbell tactically, we would view 10-year U.S. Treasury yields closer to or lower than 3% as overvalued and near the lower end of our rate expectations. For portfolios with shorter duration profiles seeking to extend, 10-year U.S. Treasury yields near or above 4% would be an attractive opportunity to execute. This trading range will likely shift as the impact of the Fed’s tightening more fully emerges.

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