Fixed income back in the spotlight. How investors can take advantage

Fixed-income investing is entering an exciting new era, and investors should take notice. Decades of low interest rates, engineered by global central banks, have suppressed the bond market’s ability to generate attractive and reliable returns.

But in recent quarters, we have witnessed a dramatic shift higher in interest rates, a move that investors should not fear but embrace. Bonds are now all the rage in investing circles and, although not as trendy as Taylor Swift, their popularity has certainly risen in recent months alongside interest rates.

Interest rates have increased dramatically since the beginning of 2022. As an example, the yield-to-maturity on the benchmark U.S. 10-year Treasury is now nearing 5%, up over 3.30%.

The yield on the 10-year and other Treasury bonds is now the highest since the onset of the Great Financial Crisis in 2007. In addition to the rise in nominal interest rates, we have also experienced a similar increase in real interest rates (rates adjusted for inflation).

If we use market-derived, forward-looking expectations of inflation to adjust nominal yields, the current real yield on a 10-year Treasury is approaching 2.5%, a level that should excite bond investors.

Granted, the journey to higher yields has been painful to bond investors. In 2022, the total return of the Bloomberg Aggregate Bond Index, a broad universe of U.S. taxable bonds, posted a return of -13.01% (according to Bloomberg as of Dec. 31, 2022), the worst calendar year performance for this index since its inception in 1976.

Other bond market sectors experienced similar distress, but with the pain comes the gain. Higher rates can now provide more total return and more stability in returns going forward.

When calculating fixed-income returns for most bonds, there are two components: price return and income return.

At the start of 2022, there was little income being generated from high-quality bonds. The negative total returns for the year were driven by large price declines with a small positive contribution from income.

As an example, the Bloomberg Aggregate Bond Index posted a price return of -15.3% and an income return of +2.3%. However, the yield-to-maturity on the Bloomberg Aggregate Index is now 5.64% (according to Bloomberg as of Oct. 17, 2023), over 3.5% higher than the beginning of 2022.

As a result, we would expect a much larger positive contribution to future returns from income and a less negative contribution from price return.

We would suggest that investors reassess their current bond allocation and marginally increase their exposure in a manner consistent with their portfolio’s current position, investment objectives and risk tolerance.

While we are not calling the top in near-term rate movements, we do believe we are entering more of a range-bound yield market for longer maturity bonds. This is consistent with our expectations of no additional rate hikes from the Federal Reserve this cycle and a continued decline in near-term inflation.

To efficiently capture the higher yields, we would advise a modest increase in longer-dated maturity bonds as well as an allocation to shorter maturity bonds in a barbell approach, while avoiding intermediate maturity where possible.

Given the inverted shape of the yield curve, a barbell approach can help maximize the overall yield of the portfolio and provide additional return should long-end rates move lower.

For non-taxable or investors that are not tax-sensitive, we would prefer the use of higher-quality corporate bonds, as we believe the market has not appropriately priced the risk of a potential recession in lower-quality bonds.

Additionally, the agency mortgage-backed securities market is a high-quality sector for investors to consider. Year to date, this sector has underperformed other investment grade sectors and now offers an attractive risk-return profile.

For those investors in high-income tax brackets, municipal bonds are attractive. Similar to our view on taxable bonds, we would recommend a bias toward higher-quality bonds as a potential recession could negatively impact lower-rated municipalities.

While we currently favor municipal bonds for those high-tax investors, we would not eliminate corporate bonds or other taxable securities from consideration. Certain market conditions can favor taxable bonds on an after-tax, risk-adjusted basis.

It’s important that investors select a manager who can take advantage of those opportunities when they arise to create a tax-efficient portfolio.

To the extent that interest rates move significantly higher, counter to our expectations, we would view this as an opportunity for investors to lock in even higher yields for longer. Under such a scenario, we would not expect a repeat of 2022 bond market returns.

We estimate that interest rates would have to increase by 0.70% to 1.00% before forward-looking 12-month total returns would turn negative for the major bond indexes.

We have little doubt that the heightened level of market volatility will continue into 2024. Opportunities present themselves when market volatility increases.

To that end, we recommend an active approach to fixed-income management. Having the flexibility to successfully navigate and benefit during challenging markets allows for better returns.

It is a new dawn for bonds and fixed-income investors. Return expectations are the highest in years and, although markets could remain volatile, now is the appropriate time to reassess your portfolio and consider an increase in your fixed-income allocation.

— By Christopher Gunster, head of fixed income at Fidelis Capital