Over the past year, the fixed income markets have experienced one of the largest and swiftest increases in bond yields on record. Bonds, which historically have provided stability and income in a diversified portfolio during equity bear markets, have done neither in 2022.
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, driving down total returns to a level only marginally better than the sharply negative returns of the stock market.
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 (Fed) 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 pushed yields on investment-grade corporate bonds to over 6%.
After years of paltry yields, the opportunity set in the fixed income markets now offer significantly more value. Furthermore, this significant revaluation of the bond market, with meaningful yield opportunities, should provide more of a buffer to a diversified portfolio if the equity bear market persists.
What are the opportunities and risks in the various sectors of the fixed income markets after such a significant revaluation of this very large and important segment of the capital markets?
Cash and money market securities. Cash is truly no longer “trash.” After years of paying practically nothing, money market securities and funds now provide yields that approximate 2.75 to 3% – and which are almost certainly going higher as the 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.
Short/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 to 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 to 6%. The main risk 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.
Investment-grade corporate bonds. With both interest rates and credit spreads moving significantly higher over the past year, corporate bonds now may provide much more compelling yields. 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. Although the economy is showing some recessionary signs, the labor market remains incredibly resilient, the banking system is quite sound, and corporate debt levels are reasonable. As such, corporate bonds look relatively attractive at current yield levels.
High yield bonds and leveraged loans. It is somewhat surprising that year-to-date, the high yield market has performed better than its investment-grade bond market counterpart, 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 to 10.0%, which are 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 are commensurate with longer term equity returns going forward. The key risk with this market is the potential for a deep recession which would escalate defaults more than are currently priced in. With a highly uncertain economic environment currently, investing in this high-risk sector of the market will require some patience.
Municipal bonds. It is difficult to make general comments about valuation in the municipal bond market given that it is such a non-homogenous market in terms of credit quality, security characteristics, and varying 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 looks compelling, but only for higher tax bracket investors. Like corporate bonds, the big risk with municipal bonds is credit quality. In addition to the risk of economic weakness pressuring municipal credit quality, contentious political circumstances could add another dimension to credit risk.
Alternative fixed income. Like the high yield market, fixed income alternatives collectively have provided a modest performance advantage over conventional fixed income sectors. Surprisingly, some high dividend paying sectors of the equity market, which can be considered fixed income surrogates, performed quite well. Utility stocks have suffered only modest declines year-to-date, while energy related dividend paying equities, such as Master Limited Partnerships (MLP), performed exceptionally well. Preferred stocks, however, performed poorly given their long duration and subordinated position in a company’s capital structure. Selective fixed income alternatives continue to be attractive given their current high income and diversification benefits. Specifically, opportunities in the preferred sector seem compelling, as do specific opportunities in mortgage-backed securities, some MLPs, and discounted closed end funds. However, astute security selection is required given the very idiosyncratic nature of the alternative fixed income market.
After such a dramatic re-valuing of the fixed income market in just the past nine months, real opportunities for income and diversification now are present after years of yield drought. Some higher risk areas of the market may even be considered attractive as equity surrogates for long-term returns. At new 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.
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.