Strong recent performance in fixed income warrants a second visit to assess opportunities.
Coming up, the current state of the bond market and the income opportunities within.
From Thrivent Asset Management, welcome to episode 44 of Advisor’s Market360™. A podcast for you, the driven financial advisor.
Today, we’re taking a well-deserved follow-up look at the bond market. Consider this a sequel to episode 40 from November of last year, in which we discussed opportunities following autumn’s peak in interest rates and bond yields. Since then, the opportunity set in fixed income has changed in the wake of recent strong performance.
Interest rates and credit spreads have gone down, bond prices have gone up, and returns in the bond market have been exceptional. Fixed-income returns have ranged from 3% to more than 10% over the past three months – depending on maturity and sector – outpacing the S&P 500® which is up nearly 5% for this time period. As a reminder, the S&P 500 index tracks the average performance of 500 U.S. large-cap companies.
With strong fixed-income performance packed into such a short period, how has the opportunity set changed, and what do we expect of the various income-oriented sectors of the market?
The Federal Reserve, or Fed, has been busy delivering on its policy of combatting inflation. Short-term interest rates have increased twice since October 31 of last year, brought up from 3.25% to the current rate of 4.5%.
During this same period, however, we've seen Treasury bond yields fall by 30 basis points on two-year Treasury bonds, and by about 60 basis points for all maturities longer than two years. Short-term yields became substantially higher than longer-term bond yields, creating a significant inversion in the yield curve. Why? Well, the market is beginning to believe that the Fed will soon stop raising rates as evidence accumulates of a slowing economy and inflation.
Meanwhile, spreads – the yield investors demand for assuming default risk on corporate bonds – have declined between 30 and 50 basis points, depending on credit quality. This decline in credit spreads points to the market’s belief that a severe recession can be avoided, resulting in a rare "soft landing" for the economy, following a period of tightening Fed policy moves.
Inflation, as always, plays a crucial role in determining fixed-income returns. We've seen inflation moderate from the high levels seen in the past year. This welcome development has brought with it lower bond yields. However, the recent sharp decline in bond market yields suggests that we may see even more significant declines in inflation down the road, and even prices in inflation to approach the Fed’s goal of 2%. Could inflation decline to this level in the next 6–9 months? We think that’s an overly optimistic expectation.
Despite the recent rally in bond prices and the diminishing prospects of near-term capital gains, the bond market still offers more compelling long-term income opportunities when compared to the almost trivial yields of the past decade.
Here’s our list of 4 fixed-income opportunities.
Let’s begin with cash and money market securities. The Fed has indicated that they will continue to increase short-term interest rates over the next 3–6 months, which means that money market funds may continue to benefit from higher yields. Currently, money market funds yield around 4%, and it’s expected that the Fed will continue raising rates to a "terminal" level of 5%. If that happens, money market fund yields may increase accordingly, which would finally reward savers with higher yields.
Second, let's look at investment-grade corporate bonds. With a sharply inverted yield curve, short- and intermediate-maturity bonds offer attractive income on a risk-adjusted basis. Bonds with maturities under 10 years have yields only slightly lower than those with maturities greater than 10 years, but shorter bonds have only a fraction of the interest rate risk, or duration. As of now, even if short and intermediate bond yields were to rise to the peak levels of last fall – which would be an increase of about 100 basis points – overall returns would be almost flat. That’s an unlikely scenario, making the risk-return profile for this segment compelling.
Longer-maturity corporate bonds have our attention, as well. Since the fourth quarter of 2022, they’ve seen an incredibly strong rally which has continued into the new year. After significant price gains, current yields are now around 5%, with select credits providing yields greater than 6%. The probability of additional capital gains in the near term seems low, but in the long term, if inflation continues to recede, longer-maturity bonds may provide a solid foundation for the income-generating segment of an investor's portfolio.
Next, let's talk about high-yield bonds. Like other segments of the bond market, these have performed well over the past three months. The average yield of the Bloomberg U.S. Corporate High Yield Bond Index, which tracks fixed-rate non-investment-grade bonds, has dropped from around 9.5% at the end of October 2022 to about 8.25% in late January. With the current additional credit risk spread to Treasuries of around 4.5%, the valuation for this higher-risk segment of the bond market is rather “rich” compared to historical averages and periods of recession.
Now, in light of the uncertain economic situation and the possibility of a recession, investors need to take into account the cost of default losses from current yield levels. Historically, default losses can reduce the overall return of high-yield bonds by 2–4%. But, assuming current yield levels of 8.25%, if the economy were to fall into a recession that causes widespread credit problems and defaults, the realized overall long-term returns one would see could be cut by 4–6%. In a recessionary environment, short-term performance is likely to be even lower as market prices for high-yield bonds would decline in recognition of a higher-risk environment.
The fourth and last item on our list: alternative income investments – specifically, emerging market debt, preferred stocks, closed-end funds, high dividend-paying stocks, and master limited partnerships. These performed well since the beginning of the fourth quarter of 2022. Emerging market debt and U.S. preferred stocks had double-digit returns during this period, while high dividend-paying stocks generated more mundane returns of 4–6%, depending on the sector. This eclectic group of income alternatives tends to do well when risk assets overall perform well.
Lending to the “eclecticism” of this group of higher income securities is how variable the investment returns can be, depending on security and sector. A shift in investor sentiment in the current environment has seen investors gravitating towards more value- and income-oriented investments. This shift may continue to benefit this diverse area of the markets and could add value to an investor's overall portfolio by potentially generating current income yield levels of 6–8%.
In summary, there are signs that inflation is decreasing and the Fed may ease up on its tight policy stance. However, the market has already priced in this favorable news, maybe even more than it should. It appears that inflation statistics going forward will have to continue to exceed the market’s expectations for bond yields to remain at current levels or decrease further.
After a surge in overall performance for fixed income assets in just the past three months, the chance of additional capital gains from falling interest rates seems to be low. However, income levels across almost all fixed income sectors remain at levels that still provide overall benefits for investors seeking income and diversification for their portfolios.
Thanks for listening to this episode of Advisor’s Market360™. All episodes are available on Apple Podcasts, Spotify, and Google Podcasts. Email us at email@example.com with your feedback, questions and topic suggestions for future episodes. Advisors: do you have a story share? Email us and you might hear it in a future episode. And as always, 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 January 31, 2023, unless otherwise noted.
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.