Since the fall of 2022 when interest rates and bond yields hit their peak, credit spreads and interest rates have both declined, driving stellar short-term returns in the bond market.  (See: Rising bond rates offer improved income opportunities for investors)

Over the past three months, fixed income returns have ranged from 3% to more than 10%, depending on maturity and sector. By comparison, the S&P 500 is up about 5% over the same span.   

After such a significant stretch of strong performance in a relatively short period of time, how much has the opportunity set in fixed income changed, and what are the expectations for the various income-oriented sectors of the market? 

Same Fed policy – Changing market expectations

Since October 31, 2022, the Federal Reserve (Fed) has increased short-term interest rates twice, from 3.25% to the current level of 4.5%. However, during that same time, Treasury bond yields have fallen by 25 basis points on two-year maturity Treasury bonds, and approximately 50 basis points for all maturities longer than two years. As a result, short term yields have become substantially higher than longer term bond yields, creating a significant inversion of the yield curve.

The reason for this profound inversion is the growing market perception that the Fed will soon stop raising rates in response to mounting evidence that both the economy and inflation are slowing. 

Meanwhile, spreads (the incremental yield investors demand for assuming default risk on corporate bonds) declined by approximately 30 to 50 basis points depending on the credit quality. This substantial decline in credit spreads reflects a growing belief that a severe recession will be averted, providing a rare soft landing for the economy.

Fixed income opportunities – Diminished, not eliminated

Inflation, as always, is the key variable affecting fixed income returns. Inflation is clearly moderating from the extremely high levels of the past year, and lower bond yields have reflected this welcome development. However, the sharp decline in bond market yields over the past three months now implies even more significant declines in inflation may follow, even pricing in expectations that inflation will ultimately approach the Fed’s goal of 2%. But we believe that expectations of inflation declining to this level in the next six to nine months is overly optimistic. 

Although bond prices have staged a significant rally recently, and the prospect of near-term capital gains has diminished some, the bond market still provides improved long-term income opportunities relative to the trivial yields of the past decade. 

Cash and money market securities. With the Fed indicating that it will continue to hike short-term interest rates over at least the next three to six months, money market fund yields may continue to rise. Currently, money market funds yield approximately 4%. Expectations are that the Fed will continue raising rates to a terminal level of 5%. If that happens, money market fund yields may rise commensurately. At long last, savers are being rewarded with higher yields! 

Short/intermediate maturity bonds. With a sharply inverted yield curve, shorter maturity bonds continue to provide compelling income on a risk-adjusted basis. The Bloomberg Intermediate Maturity Corporate Bond Index, which measures the performance of U.S. corporate bonds with a maturity of less than 10 years, recently had a yield of just under 5%. But it carries a duration (a measure of interest rate risk) that is only 30% of the Bloomberg Long Maturity Corporate Bond Index, which measures the performance of U.S. corporate bonds with a maturity of 10 years or more, that has a yield of just over 5%. Currently, even if short/intermediate bond yields shot back up over the next year to the peak levels of last fall (100 basis points), overall returns would be about flat. With the probability of that scenario currently low, the risk/return profile for this segment of the fixed income market remains compelling. 

Investment grade corporate bonds. Longer maturity corporate bonds have experienced an incredibly strong rally that began in the 4th quarter of 2022 and has continued into the new year. After significant price gains, current yields on corporate bonds are now approximately 5%, with selected credits providing yields greater than 6%. In the near term, the probability of additional capital gains in this area seems low. However, from a longer-term perspective, if inflation continues to recede, longer maturity corporate bonds may provide a decent core for the income-generating segment of an investor’s portfolio. 

High yield bonds. Like other segments of the bond market, high yield bonds performed well over the past three months. The average yield of the Bloomberg High Yield Bond Index, which measures performance of non-investment grade corporate bonds, declined from approximately 9.5% at the end of October 2022 to approximately 8.20% in late January. With the additional credit risk spread to Treasuries of about 4.20%, valuation for this higher risk segment of the bond market is somewhat rich relative to historical averages, and quite rich relative to periods of recession. Given the uncertain economic situation and the possibility of a recession, investors need to take into consideration the cost of default losses from current yield levels.  Historically default losses can reduce the overall return of high yield bonds by 2 to 4%. Therefore, at yield levels of 8.25%, overall realized long-term returns could be cut by 4 to 6% if the economy falls into a recession that causes more widespread credit problems and defaults. In a recessionary environment, short-term returns would likely to be even lower, as market prices for high yield bonds would decline due to the higher risk environment.   

Alternative fixed income. Alternative fixed income investments, which include emerging markets debt, preferred stocks, closed end funds, high divided stocks, and master limited partnerships, have also performed well since the beginning of the 4th quarter of 2022. Emerging markets debt and U.S. preferred stocks had double-digit returns during this period, while high dividend paying stocks generated relatively more mundane returns of 4 to 6% depending on sectors. This eclectic group of income alternatives tends to do well when risk assets overall do well.  

Given this is an eclectic group of higher income securities, investment returns for individual securities and sectors in this group can be quite varied. The current investing environment has shifted to one where investors are gravitating to more value and income-oriented investments. This shift in market sentiment may continue to benefit this heterogenous area of the markets, and could add value to an investor’s overall portfolio by potentially generating current income yield levels of 6 to 8% 

In summary, we expect fixed income to play a diversifying role in portfolios in contrast to 2022 when both fixed income and equities posted negative returns. Fixed income may offer greater income opportunities versus the yield drought of the past few years.

Inflation has slowed and we expect further declines as 2023 progresses. Lower inflation along with the risk of a significant economic slowdown or recession should pressure longer-term yields lower, although the path could be volatile given uncertainties over the Fed and economy. The risk to this view is stickier inflation and a stronger economy than expected, which could drive rates higher.

Additionally, yields for nearly all the sectors of the fixed income markets remain at levels that still may provide overall benefits for investors pursuing income opportunities for their portfolios along with diversification.