Opportunities in fixed income as bond rates rise

The drought is over. No, not the one gripping the Western U.S., the one that has gripped fixed income markets for years.

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From Thrivent Asset Management, welcome to episode 40 of Advisor’s Market360™. A podcast for you, the driven financial advisor.

At some point, the drought in fixed-income markets had to end. And over the past year, the rains came – with fixed-income markets experiencing one of the largest and swiftest increases in bond yields on record.

In fact, during the first three quarters of 2022, treasury bond yields across the maturity spectrum have surged to over 4% – a level not seen in over 14 years.

High quality mortgage-backed securities, which have been roiled by a doubling of interest rates in underlying new mortgages, and uncertainties over the Federal Reserve’s immense mortgage portfolio, saw yields increase to over 5%. Meanwhile, as the economy showed signs of moving into recession, credit spreads moved significantly wider as investors required more yield premium to compensate for increasing credit risk. This added risk premium has pushed yields on investment-grade corporate bonds to over 6%.

After years of paltry yields, the opportunities in the fixed-income markets now offer significantly more value. Further, this significant revaluation of the bond market, with meaningful yield opportunities, should provide more of a buffer to a diversified portfolio if the bear market in equities persists.

What are the opportunities and risks in the various sectors of the fixed-income markets after such a significant revaluation? We’ve got six sectors to cover, so let’s dig in…

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First up on our tour of fixed income instruments are cash and money market securities. The headline here is – cash is no longer “trash.” After years of paying practically nothing, money market securities and funds now provide yields that approximate 2.75–3%. These yields are almost certainly going to go higher as the Federal Reserve, or Fed, continues to raise interest rates into 2023. Savers and investors were finally able to earn a reasonable return on what is considered to be a safer sector of their portfolio.

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Secondly, short and intermediate maturity bonds. Yields in this sector of the market have risen the most as the Fed has raised rates and the yield curve has inverted. Short-maturity Treasury securities, with yields of 4–4.4%, are already pricing in an increase of at least another 125 basis points in short-term interest rates.

Short-duration corporate, mortgage, and asset-backed securities now provide current yields of 5.5–6%. The main risk with these bonds is that the Fed moves more aggressively than expected in its efforts to thwart inflation. However, this sector of the market, with very moderate interest rate risk, may still be able to generate positive returns going forward even if interest rates move moderately higher than expected.

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The third fixed income sector on our list is investment-grade corporate bonds. These may now provide much more compelling yields due to the increases in interest rates and credit spreads. The Bloomberg Corporate Bond index now has an average yield of approximately 6%. A deep and prolonged recession, with the potential for even wider credit spreads, is the key risk factor for this sector. But, despite recession concerns, the labor market and the banking system remain resilient, and corporate debt levels are reasonable. So, corporate bonds look relatively attractive at current yield levels.

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And fourth: we turn our attention to high-yield bonds and leveraged loans. In a surprising development, year to date, the high-yield market has performed better the investment-grade bond market, although returns are still sharply negative. Currently, the Bloomberg High Yield Bond Index and the JP Morgan Leveraged Loan Index have average yields of 9.5–10%. These yields are properly pricing in higher default losses in the future. At these yield levels, this higher-risk sector of the fixed income market may provide returns that correspond with longer-term equity returns going forward. The key risk with this market is, once again, the potential for a deep recession which would escalate defaults. With the current uncertainty in the economy, investing in this high-risk sector of the market will require some patience.

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Fifth: municipal bonds. Where does the current environment leave these? First, it’s important to remember there are difficulties in determining valuation in the municipal bond market. That’s because of the wide variation in credit quality, security characteristics, and different state income tax rates. The average yield on investment-grade municipal bonds is currently about 4%, while higher-risk, below-investment-grade municipal bonds are paying an average yield of more than 6%.

When adjusting these returns for taxes, the municipal market does look compelling, but only for higher tax bracket investors. Like corporate bonds, the big risk with municipal bonds is credit quality, which is put under pressure by economic weakness. Contentious political circumstances could add another dimension to credit risk.

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The sixth and last area we’re covering: fixed-income alternatives. Collectively, they have provided a modest performance advantage over conventional fixed-income sectors. Another surprise: the high dividend-paying sectors of the equity market, typically considered to be fixed income surrogates, performed quite well year to date. One such sector is Utilities, which have suffered only modest declines year-to-date, while dividend-paying Energy equities, such as Master Limited Partnerships, or MLPs, performed exceptionally well.

Preferred stocks, however, performed poorly given their long duration and subordinated position in a company’s capital structure. Certain fixed-income alternatives continue to compel due to their current high income and diversification benefits. Specifically, we are talking about the preferred sectors, a number of mortgage-backed securities, some MLPs, and discounted closed-end funds. Remember, that the alternative fixed-income market is very idiosyncratic and discernment in security selection is required.

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To sum it up, the fixed-income market has experienced a dramatic revaluation in the past nine months. Right now, real opportunities for income and diversification have presented themselves after years of yield drought. Some higher-risk areas of the market may even be considered attractive as equity surrogates for long-term returns. With much higher yield levels, Treasury securities and other high-quality fixed-income assets are valued such that they should be able to resume their historical diversification benefits as a portfolio shock absorber if the bear market in equities persists.

It's important to note that the risk of accelerating inflation remains as a cloud over not just the fixed-income markets, but equities as well. If inflation remains at elevated levels, not only will investors be unable to earn positive real inflation-adjusted returns, but the Fed may feel compelled to move more aggressively to tighten policy, sending markets even lower.

Currently, there are a few early indicators that inflation is peaking but certainly not enough to provide evidence for the Fed to conclude that inflation is abating and that a policy pivot is at hand. However, current valuation in many sectors of the fixed-income market are pricing in this reality. 

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Thanks for listening to this episode of Advisor’s Market360™. All episodes are available on Apple Podcasts, Spotify, and Google Podcasts. Email us at podcast@thriventfunds.com with your feedback, questions and topic suggestions for future episodes. We’re also looking for stories from financial advisors about times when you’ve made an impact in your clients’ lives! Email us your story at podcast@thriventfunds.com and it could be featured in a future episode. You can learn more about us at thriventfunds.com and find other insights of interest to you, the driven financial advisor. Bye for now.

All information and representations herein are as of November 1, 2022, unless otherwise noted.

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Any indexes discussed are unmanaged and do not reflect the typical costs of investing. Investors cannot invest directly in an index.

Past performance is not necessarily indicative of future results.

Actual investment decisions made by Thrivent Asset Management, LLC will not necessarily reflect the views expressed. This information should not be considered investment advice or a recommendation of any particular security, strategy or product. Investment decisions should always be made based on an investor's specific financial needs, objectives, goals, time horizon, and risk tolerance.

Thrivent Asset Management, a division of Thrivent, offers financial professionals a variety of investment products to help meet their clients’ needs. Thrivent Distributors, LLC, is a member of FINRA and SIPC and a subsidiary of Thrivent, the marketing name for Thrivent Financial for Lutherans.