Core bond investors have experienced the worst start to the year ever. However tough this year has been so far, the potential for future returns has improved meaningfully. Starting yields tend to be a good predictor of future returns and have become more attractive in several markets. With yields on most fixed income markets having moved sharply higher, now could be a good time to revisit fixed income.
The value proposition for core bonds (as defined by the bonds within the Bloomberg Aggregate Bond index) is that they tend to provide potential for liquidity, diversification (to potentially counter equity market risk), and add positive total returns to portfolios. Unfortunately, none of those values are 100% certain all the time. Like all markets, fixed income investing involves risks and, at times, negative returns. Despite the historically poor start to the year, the value proposition for core bonds has improved. Investing is a forward-looking exercise, and with the back up in yields having already taken place this year, now could be as good as it has been in quite some time.
Importantly, yields are moving higher because of the expectations of higher short-term interest rates and not an increase in credit risk. Coming into the year, markets were only expecting one or two short-term interest rate hikes by the Federal Reserve (Fed) with most of the hikes expected to come in 2023. However, markets have aggressively re-priced the number of expected Fed rate hikes and now expect as many as 11. As such, the yield on the 10-year Treasury security has doubled this year after increasing around 100 basis points (1.00%) off its lows in 2020. The 260-basis point (2.6%) move higher is the biggest move higher in yields since 1994, when rates moved higher by 280 basis points, and that was at the end of the rate hiking cycle. With so many rate hikes priced in at this point, hopefully, the worst is behind us.
Have rates peaked? Historically, rates have tended to move a lot before the first rate hike (like they have already done this year), but they still move marginally higher throughout the rate hiking process and do not actually make a top until the Fed stops raising rates. This cycle has only just started. That does not mean we will see significantly higher yields. We could see 3.25-3.35% on the 10-year this year, which would likely be the top end of the range in yields for this cycle. However, yields are likely to trade between 2.75-3.0% for most of the year and then fall slightly from current levels with the 10-year Treasury yield ending the year around 2.5%.
TINA, or “there is no alternative,” has been a big reason diversified asset allocation portfolios have been overly geared towards equities over the past few years. The relative attractiveness of equities over fixed income was undeniable when interest rates were
hovering around all-time lows. Now that interest rates have moved higher, the relative attractiveness between the two broad asset classes is much more balanced.
For investors unwilling or uninterested in taking on additional equity risks, there are several fixed income markets with yields trading above long-term averages. The yield-to-worst on most fixed income asset classes is hovering around the highest yields seen in a decade. And for the Bloomberg Aggregate index, which is the broad-based core bond index, outside of two months in 2018, yields are the highest they have been since 2010. Since starting yield levels have been a good predictor of future returns, future returns look more attractive than they have in years. The back-up in yields could be an attractive opportunity for suitable income-oriented investors.
We tend to have a pretty good idea what to expect out of many fixed income instruments over time because coupon and principal payments are known in advance and contractually obligated. As such, whether you are invested in an individual bond, an investment that tracks an index like the Bloomberg Aggregate index, or a strategy designed to actively outperform an index, returns are largely predicated on starting yields. This is true if you hold the fixed income instrument to maturity (for an individual bond) or at least five years (for a portfolio of bonds) regardless of what interest rates do in the interim. That is, if you buy and hold a fixed income investment, the short-term volatility you experience due to changing interest rate expectations is just volatility. It has very little bearing on the actual total return if held to maturity (or if held to the average maturity of a portfolio of bonds).
Since 2000, the correlation between stocks and bonds has generally been negative. At times, the relationship between stocks and bonds has, in fact, been positive (from 1965 to 2000, correlation was slightly positive due to higher inflation and more frequent inflationary shocks). So, the historical correlation between stocks and bonds is close to zero—meaning it is generally noisy. In other words, it is not uncommon to see equity and bond prices moving lower (or higher) at the same time.
However, now that interest rates have moved off the all-time lows set back in August 2020, there is more of a cushion to act like a diversifier during equity market drawdowns, which is what we have seen during the most recent equity market stresses over the past few weeks. Since the start of May, equities are down over 6%, whereas core bonds are positive. And without any additional macroeconomic shocks driving the divergent returns, it is comforting to see bonds providing that equity buffer, albeit over a very short time horizon. With a potential slowdown in economic growth, bonds have the potential tomitigate the risk.
Core bonds have been a staple in diversified asset allocations. However, with returns as negative as they have been this year, investors may be undergoing a rethink of the utility of core bonds. That may be a mistake. The value proposition for core bonds remains. Liquidity, equity diversification, and total returns are all valuable properties core bonds bring to diversified portfolios—and each of those value propositions have improved recently. Moreover, bonds are unique in their structures in that coupon and principal payments are, for the most part, guaranteed (unless the issuer defaults) and the primary factors of long-term total returns. The price volatility we have seen so far this year does not impact those payments. And with yields higher in many markets, now may be a good time for suitable investors to start looking at additional investment opportunities within fixed income.
The economic forecast set forth in this presentation may not develop as predicted, and there can be no guarantee that strategies promoted will be successful.
Data provided by LPL Financial, tracking #1-05284424.
Indexes are unmanaged statistical composites and cannot be invested into directly. Index performance is not indicative of the performance of any investment and do not reflect fees, expenses.
US Treasuries may be considered “safe haven” investments but do carry some degree of risk including interest rate, credit, and market risk. Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and bonds are subject to availability and change in price.
The Bloomberg Aggregate U.S. Bond Index represents securities that are SEC-registered, taxable, and dollar denominated. The index covers the U.S. investment-grade fixed rate bond market, with index components for government and corporate securities, mortgage pass-through securities, and asset-backed securities.
The Standard & Poor’s 500 Index (S&P500) is a capitalization-weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.