The three phases of fixed-income investing
“If you make the mistake of looking back too much, you aren't focused enough on the road in front of you.”
– Brad Paisley
We’ve used this quote from Brad Paisley many times over the past year because it‘s such a great way for investors to frame their thoughts when it comes to investing. This has been a very tough year for investors, not only in equities but also in fixed income. This will likely end up being one of the worst years in history for fixed-income and balanced-fund investors.
Let’s take a quick look back as to why this might be the case. First, we need to understand the dynamic between bond prices and yields, which have an inverse relationship (meaning when yields increase, the price of a bond decreases). At the beginning of the year, when inflation was determined to be much more enduring and elevated than expected, central banks across the world undertook an aggressive approach to increasing interest rates with the goal of pushing inflation lower. Yields increased in Canada and the United States from 1.4% to 3.1% and 1.5% to 3.8% respectively, measured by the 10-year government bond yields. This spike in yields led to bond prices falling.
Typically, investors use bonds for income and to decrease downside portfolio volatility, as bonds typically act as a counterbalance when equities fall. In 2022, bonds didn’t do their job. This decline wasn’t an indication of the quality of the underlying business or increased risk of a default, but the result of rise in yields.
When we look at the opportunity set for bonds moving forward, we describe it in three phases: the sweet spot, duration is your friend, and take on risk.
According to the Pythagorean school, the number three, which they called triad, is the noblest of all digits. For Pythagoras, the number three was a perfect number—the number of harmony, wisdom, and understanding.
Phase one—the sweet spot
Phase one is the current phase that fixed-income investors find themselves in. Yields across most, if not all, fixed-income instruments—regardless of maturity, type, or credit quality—have moved materially higher since the beginning of this year. In this phase, investors should focus on the yield provided by the bond or “clipping the coupon.” There’s no free lunch, and to obtain a higher yield, an investor must take on some sort of additional risk, whether it be, duration, credit, or even liquidity.
In the current environment, investors aren’t required to take on additional risk to receive an attractive yield. Despite the higher yield, available in high-yield corporate credit, if we encounter an increased risk of recession, default risk may increase. We believe that the sweet spot from a risk/return perspective can be found in investment-grade corporate credit within North America. Currently, there remains little default or liquidity risk in investment-grade corporate bonds and duration tends to be between 3 to 5 years, or sometimes less. Further, the yields are the highest since before the Global Financial Crisis, as measured by the ICE BofA US Corporate Index.
In phase one, investors are essentially being paid to wait until there’s more clarity on the U.S. Federal Reserve’s planned interest rate hikes and the health of the economy. This approach helps mitigate both duration risk from yields continuing to move higher and credit risk if we see default expectations increase in lower-quality bonds.
Various fixed-income asset classes' yield to worst
12/31/2021 vs 8/31/2022
Source: Bloomberg, Manulife Investment Management, Capital Markets Strategy, as of October 31, 2022. Proxies that represent these asset classes: Global Bonds – Bloomberg Global Aggregate Bond Index, Canadian Credit – FTSE Canada Universe Bond Index, Canadian Government Bonds – FTSE Canada All Government Bond Index, US Government- Bloomberg US Treasury Index, US Credit – Bloomberg US Corporate Bond Index, US High Yield – Bloomberg US Corporate High Yield Bond Index. It’s not possible to invest directly in an index.
Phase two—duration is your friend
As we transition into the first half of next year, we expect economic conditions to weaken materially, and we’re likely going to see a mild recession in both Canada and the U.S. We’re also likely to be near the end of the interest-rate tightening cycles of the Bank of Canada and the Fed.
In this second phase, we want to begin embracing longer-duration and higher-quality fixed-income instruments, such as 10-year government bonds. Duration is the bond price’s sensitivity to interest rates. When the market begins to anticipate the end of the rate-hike cycle, yields across the U.S. Treasury curve tend to have already hit their peak, meaning that the downside risk of duration becomes minimal.
As the markets’ expectations shift from rate hikes to rate cuts, the yield curve tends to fall with the 2-year yield, falling more than the 10-year. This may not be as much the case in the near term. Many investors have alluded to Fed Chair Jerome Powell embracing his inner former Federal Reserve Chair Paul Volcker, as he has pointed to the need to get inflation under control regardless of the potential for a recession. During the press conference after the Fed’s most recent meeting he commented: “If we were to over-tighten, we could then use our tools strongly to support the economy, whereas if we don't get inflation under control because we don't tighten enough, now we're in a situation where inflation will become entrenched and the costs, the employment costs in particular, will be much higher potentially. From a risk management standpoint, we want to be sure that we don't make the mistake of either failing to tighten enough, or loosening policy too soon.”
If Powell is a student of history and wants to mimic what Volcker did in the late 70s and early 80s to tame inflation, he’ll also want to avoid Volcker’s key mistake, which was to sharply cut rates in 1980 at the first sign of a recession, only to have to sharply raise them. Unfortunately, inflation hadn’t yet begun to soften enough, and Volcker quickly reversed course by raising rates again leading to a second recession that was far worse from an employment perspective and lasted much longer than the first.
We need to remember that full employment is the second mandate of the Federal Reserve. Given how tight the employment market is, there’s room for the unemployment rate to increase during any potential recession without the need for the Fed to make an abrupt change in tone and cut rates materially to avoid a recession. It’s likely that this time the long end of the Treasury yield curve will decline before the short end of the curve.
As the market starts to expect an elevated risk of recession, yields tend to fall. Since 1976, when the U.S. was in a recession, the 10-year U.S. Treasury yield fell by 35% on average. This means that the duration risk that was a headwind to bond returns as yields rose (remember the inverse correlation between yields and price?) eventually becomes a tailwind, as the combination of longer duration and falling yields tends to enhance bond returns.
In phase two, by increasing duration and quality while transitioning to longer-dated government bond yields, investors will potentially be mitigating risk while also potentially increasing their return opportunity.
U.S. 10-year Treasury yield
1976 – November 2022
Source: Bloomberg, Manulife Investment Management, Capital Markets Strategy, as of November 17, 2022.
Phase three—take on risk
The final phase of the opportunity in fixed income is the “A-ha!” moment, as we want to take on risk when markets have fully priced in a recession. Typically, when that happens, you see high-yield corporate bond spreads widen and factor in an elevated risk of defaults. The number of defaults is often overexaggerated, and active managers with deep credit research capabilities can take advantage of dislocations between the expected default risk and the actual one. Taking on credit risk can potentially lead to strong returns in fixed-income portfolios, as high yield has historically performed well over the twelve months following the trough in performance. Since inception of the US High Yield Index in December 1996, during recessions, its spreads have averaged 1006 basis points. Historically, when US High Yield spreads are greater than 1000 bps, forward 12-month returns have averaged 28.8%.
In phase three, taking on credit risk may be beneficial for investors. During recessions, the markets tend to expect a higher level of defaults than what actually occur, resulting in larger spreads. When the market realizes the error of its ways, spreads tend to tighten, which drives returns in high-yield bonds higher.
High-yield bond 12-month returns following spread levels at month end
1997 – November 2022
Source: Bloomberg, Manulife Investment Management, Capital Markets Strategy, as of November 17, 2022
These three phases of fixed income by no means cover all the opportunities that exist, and likely oversimplify a very complex asset class. But it does try to illustrate the multiple opportunities that active fixed-income managers have at their disposal during different economic and market environments. What investors experienced this year was extremely rare and we believe now more than ever we must focus on the road in front of us to make sure we remain on the path to our end destination, whatever that may be.
A rise in interest rates typically causes bond prices to fall. The longer the average maturity of the bonds held by a fund, the more sensitive a fund is likely to be to interest-rate changes. The yield earned by a fund will vary with changes in interest rates.
Currency risk is the risk that fluctuations in exchange rates may adversely affect the value of a fund’s investments.
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