- The dramatic reversal in central bank policy over the past year and a half has created plentiful opportunities in many segments of the bond market, as well as meaningfully higher yields.
- With a pause from many of those same central banks either imminent or under way, now could be an opportune time for investors to revisit their fixed-income allocations—especially those riskier positions that seemed necessary in a lower for longer environment.
- Time may be of the essence: While there may be more runway than markets currently anticipate, by the end of the year we could see a meaningful slowdown in developed economies, a shift to easing policies from central banks, and falling yields across the bond market.
In the summer of 2007, as the extent of the global financial crisis was only just beginning to reveal itself, the yield on 10-year U.S. Treasuries slipped below the 5% threshold. In the 16 years since then, 5% remains a level yet to be reached again. Quite to the contrary, yields on the 10 year hit an all-time low of just 0.52% in August 2020 and spent nearly all of that inauspicious year trading below 1%.1 While much has changed since the depths of these twin crises, it’s worth reflecting on just how pervasive and enduring the dearth of yield has been in the bond markets. For investors seeking to generate a relatively stable income stream with a reasonable level of risk, the challenge over the last decade and a half has been huge and carried with it a certain feeling of permanence. The investment landscape seemed at the time to have taken on a new and durable state of abnormality: It often felt during that stretch that central banks’ extraordinarily accommodative policies were fixtures here to stay. With near-zero rates and ultra-accommodative policy, dialing up portfolio risk budgets in pursuit of incremental income seemed an inevitable and necessary response to a world in which debt, by many traditional measures, was nearly free for borrowers.
Then, in the span of just 16 months, everything changed. Inflation jumped from less than 2% in the United States to 9%—a 40-year high.2 The U.S. Federal Reserve (Fed) had no choice but to respond with a series of rate increases, and the investment landscape was suddenly upended to become the one we face today, characterized by stubbornly high inflation, restrictive monetary policy, and potentially overvalued asset prices. The silver lining for fixed-income investors, though, is that yield has finally returned to the bond markets. For instance, to date in 2023, yields on the 10-year U.S. Treasury have generally traded in the 3.5% to 4.0% range, which is twice the level from early last year. Meanwhile, the 3-month T-bill has experienced an even more pronounced jump, from 0.08% at the start of 2022 to 5.10% at the end of April 2023.3 Income in 2023 is no longer quite so elusive.
This sharp repricing in bond markets has had profound implications for fixed-income investors, especially for those who extended their risk budgets outside of historical ranges. We believe now is an opportune time for investors to recalibrate their portfolio risk and their future expectations, considering both the current market environment and the next phase looming just over the horizon.
Reaching for yield often seemed necessary in a lower for longer environment
Our core investment philosophy focuses on balancing the four main areas of perceived risk in the bond market: duration, credit, liquidity, and currency (i.e., foreign exchange). What made the past decade-plus challenging for many investors was that the pursuit of yield often meant dramatically increasing risk in any or all of these four areas. For example, at the start of 2022, the spread—or incremental income—offered in high-yield bonds over U.S. Treasuries was barely north of 3%—and Treasury yields themselves were, of course, close to zero. The pressure investors and institutions felt to move down in quality in pursuit of that income is hard to quantify, but it was very real, as numerous studies have sought to show.
The same can be said of risk-taking when it came to term premium and duration. On average, since 2000, 10-year U.S. Treasuries have offered about 120 basis points of incremental income versus 2-year securities. More recently, those spreads have been well below that 120-basis point level over the past 5 years with very few exceptions.3 Generating income in recent years therefore often required moving out in maturity, which meant taking on increased duration risk—a strategy that several banks recently discovered offered no free lunch.
Other cracks appear to be forming elsewhere in bond markets. The commercial mortgage-backed market, for example, has been an area in which investors could historically pursue incremental yield, but it’s unclear exactly how much risk doing so has entailed. Defaults in the space remain relatively low despite anemic postpandemic office occupancy rates, which have stalled out around 50% in major urban markets on both coasts in 2023. As hybrid work models become increasingly customary, it’s unclear what catalyst could bring office occupancy rates materially higher.4 Meanwhile, investors who decided to pursue yield by increasing liquidity risk through private credit allocations may discover, when their holdings are marked to market, that 2022 was as challenging a year for private market debt as it was in the public space.
Our point here is not to merely stir up anxiety, but rather to highlight the reality that risks in the bond market aren't homogenous, and they never were. Any portfolio that in recent years sought to target specific income levels within predefined risk parameters would needed to have employed a highly active, nimble approach to avoid being blindsided by the rapid changes in the market over the past year or so. It remains to be seen how many were.
Bonds have been unusually poor risk mitigators lately—but that may soon change
We’d be remiss to not acknowledge that income isn’t the only reason investors hold bonds. Reducing overall portfolio risk, especially relative to equity allocations, has always been one of the chief functions of fixed income. On that score, it’s been a particularly challenging period for investors.
While the 1-year correlation of the Bloomberg U.S. Aggregate Bond Index versus the S&P 500 Index has historically been highly volatile, we see that it tends to coalesce in a range from –0.2 to 0.2; for the decade prior to 2022 (2012–2021), the average was essentially zero, coming in at –0.02. Today, the correlation is almost 0.8 and is approaching a 50-year high.5 That’s been a bitter pill to swallow for investors who held fixed income to offset equity risk, particularly given last year’s decline of more than 18% for the S&P 500 Index, as broad-based bond exposures also produced double-digit losses.6
Looking ahead, however, we believe correlations are likely to be more in line with their historical norms. While inflation may remain elevated for some time, we believe the initial shock has been priced into markets and that a slowdown in global growth will soon be the next major event for markets to metabolize. As risk appetites diminish, we anticipate the correlation of stocks and bonds will begin to fall, and a slowdown at this stage feels increasingly likely: The IMF recently pegged its outlook for global growth over the next five years at just 3.0%—the lowest five-year forecast it’s ever published.7
For all of these reasons and more, it seems likely that we’re on the cusp of a great reawakening for bond investors, as their collective appetite for higher-quality, intermediate duration fixed-income securities—those more garden-variety holdings that were so unappealing for so long from an income perspective—returns in force.
The window for renormalizing bond portfolios may be longer than the market anticipates—but history shows it won’t last forever
With higher yields available basically across the board in the bond markets, investors have their choice of where to focus their attention: Today’s yields put more than a dozen segments in the 90th percentile or higher for observations over the past decade.
We’d generally argue for casting a wide net given this kind of opportunity set, but there’s an important caveat investors should appreciate about the opportunity the current moment provides: It’s impossible to predict how long it will last—and it may prove shorter than some investors imagine.
The futures market is currently pricing in no additional rate hikes from the Fed, which in our minds feels right. What’s noteworthy is the expected relative brevity of the pause before the Fed begins cutting. The current consensus is for lower policy rates by September, but over the past month market expectations have seen cuts as early as July. A reversal that fast would be atypical: Historically, the Fed has held rates steady for 6 to 12 months before beginning the transition to an easing policy. We believe this expected Fed pause provides an ideal window for investors to reposition their fixed-income exposures ahead of an eventual policy pivot—but we’d urge investors to avoid taking for granted that this pause will last.
Fed policy, after all, is only one factor influencing interest rates and yields. On the longer end of the curve, heightened prospects of an economic slowdown—or full-blown recession—would, as we’ve argued, likely spark increased demand for intermediate- and longer-term high-quality bonds, and as prices rise, those yields would fall as well. We’d also expect that falling correlations would fuel demand, which would also apply a downward pressure on rates.
The takeaway is that the shape and level of the yield curve changed dramatically between early 2022 and early 2023. It wouldn’t surprise us if the curve experienced another meaningful change as we move toward and through 2024—at which point, capturing high-quality fixed-income positions with compelling yields may not be quite as easy as it is today.
What now? Positioning portfolios for a bond market in transition
It’s likely no surprise that our belief about the most prudent way to navigate the coming transition is fundamentally no different than our baseline philosophy: A broadly diversified, actively managed approach allows investors to proactively respond to fluctuating risks in the markets. We see several attractive opportunities worth highlighting further.
Interest rate positioning—Over the past 18 months, investors were rewarded for having limited their exposure to interest-rate risk as central banks globally embarked on one of the most aggressive rate hiking cycles in history. As we’ve illustrated, since investors are now being compensated appropriately (in the form of yield) for the risk of any additional rate hikes, we think now is the time to begin embracing interest-rate risk: The higher income base investors earn would act as an offset to price losses should yields move materially higher from here. We also see a benefit to emphasizing global diversification when it comes to duration exposure, given that central banks throughout the developed world are at different stages of their respective interest-rate cycles—and some (e.g., Canada) are already on pause. We believe that as we move further into a late-cycle environment, there could also be benefits in allocating to countries where local economies may be more sensitive—or vulnerable—to higher interest rates. We’d expect those countries to begin cutting policy rates before the Fed is ready to move.
Credit positioning—Credit spreads have been remarkably stable despite the increasing economic uncertainty around the globe. We believe it prudent to strike a cautious stance as it relates to credit exposures at this point in the cycle and that security selection at the quality, industry, and issuer levels will be a bigger factor in determining performance going forward. Within corporate bonds, we hold a positive outlook for investment-grade and select higher-quality high-yield bonds that operate in sectors poised to benefit from the broader economic reopening, including travel, leisure, and food services. We also believe that commodity producers and more defensive industries such as healthcare, utilities, and noncyclical consumer segments can perform well in the current environment; select securitized assets are also attractive as they can diversify a portfolio away from traditional corporate credit risk. Within that space, we’re finding attractive offerings in commercial mortgage-backed securities tied to life sciences, traditional agency mortgage-backed securities, and also unique asset-backed securities.
Currency positioning—Risk-managed currency exposures can add another layer of diversification—not to mention alpha—to a portfolio. Our analysis suggests that the U.S. dollar likely peaked in late 2022 and, looking out over the medium term, we believe a less hawkish (or possibly easing) Fed policy, coupled with the potential for a shallow U.S. recession, could result in the dollar falling further. A weaker dollar would benefit international fixed-income markets; subsequently, we believe non-North American currencies have become more attractive, particularly in places such as the eurozone, where interest rates have normalized; select local emerging-market currencies from jurisdictions in which central banks have preemptively raised interest rates also look attractive from both a carry and total return perspective. We would caution, however, that within emerging markets, country selection can prove of paramount importance given elevated geopolitical, political, and liquidity risks experienced in the sector. We prefer higher-quality, liquid emerging markets with strong fiscal positions, independent central banks, and floating exchange rates (rather than pegged). Targeted exposures in Latin America (LATAM), where investors can pick up double-digit yields on short-term bonds, and Asia, which should benefit from peaking inflation and better growth prospects on the back of China’s economic reopening, both look appealing.
There are abundant opportunities for active bond pickers, but time is limited
First the positive news: We’ve rarely seen a market that presented such diverse and compelling opportunities as this one. For managers that run a global multisector portfolio, we’re able to establish and tailor positions in all corners of the market based on what we see as the relative merits, risks, and valuations. Even managers that focus on single segments or operate within narrower mandates can fine-tune their portfolios to take advantage of the fact that the risk/reward profile of so many pockets of the bond market is better than it’s been in years. The added benefit of the current higher-yield environment is that fixed-income investors no longer require central banks to cut interest rates to deliver an attractive total return. With our base-case scenario of an imminent pause from central banks, followed by a shallower rate cutting cycle in which interest rates aren't reduced all the way to the so-called zero-bound, the asset class is set up for a potential multi-year runway for attractive risk-adjusted returns.
Should the global economy deteriorate faster than anticipated, we believe the not-so-good news is that this kind of a target-rich environment won’t last for long. The Fed has been extremely aggressive in tightening over the past year, much more so than in prior cycles. That severity, while not the only factor, was certainly one of the primary drivers of the unparalleled downturn in the bond markets in 2022. The swiftness of the tightening and the severity of the sell-off are what created the opportunities we’re seeing today—and neither of those catalysts is likely to persist.
Investors who moved into lower-quality, or less liquid, or more esoteric positions have a chance to revisit the question of exactly how much risk—and what kind—they want in their portfolios. But as the Fed and other central banks get inflation more under control and begin to refocus on the economy—which in many areas is showing new signs of stress every day—it’s unlikely that central banks will need to maintain restrictive levels of interest rates and instead will need to eventually pivot to an easing stance. Whether that day comes sooner or later than expected, we believe the solution is the same: Investors should take advantage of the pause and reposition their portfolios to incorporate some of today’s abundant—and long-awaited—opportunities.
1 U.S. Department of the Treasury, as of April 30, 2023. 2 Bureau of Labor Statistics, as of April 30, 2023. 3 Federal Reserve Bank of St. Louis, as of April 30, 2023. 4 Kastle Systems, as of April 30, 2023. 5 Bloomberg, as of April 30, 2023. 6 Standard & Poor’s, as of April 30, 2023. 7 International Monetary Fund, World Economic Outlook, April 2023. 8 CME FedWatch Tool, as of May 4, 2023.
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