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Fixed Income Complacency

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Updated March 21, 2022

Steve Brudos, Portfolio Manager

The Practical Side of Fixed Income Today

Key Observations

  • Long-term falling interest rates and modest inflation prior to covid have left many investors complacent about the risks and opportunities within their fixed income portfolios.
  • We believe investors using history as a guide to how fixed income will weather a rising interest rate cycle may be missing a key difference from the past: punitively low yields.
  • Fixed income, if sized appropriately, diversified sufficiently and/or used with other asset classes, may be able to achieve favorable results despite these headwinds.  

The last time inflation was seven percent and The Federal Reserve’s Fed Funds Rate was rising, was 1979. For those keeping track, an investor in current markets who participated in such an environment would be 73 years old, or older, today. While rising interest rates, inflation and changing fixed income markets is not new, it may feel that way. Recent and even long-term history lulled some investors into fixed income complacency. To combat this, we will illuminate how fixed income works, look at where we are today and provide practical strategies for investors to employ in this environment.

Laying the Foundation: How Bonds Work

The primary source of returns from bonds comes from yield (often referred to as the coupon or the income from a bond). This makes the current yield of a fixed income portfolio both important and potentially predicative of future outcomes. The income component of fixed income securities also contributes to mitigating volatility and offsetting periods of time where the price return of bonds may be negative.

Components of Return
Source: Fiducient Advisors, Morningstar Direct. Data based on the Bloomberg U.S. Aggregate Price and Total Return Indices. Price return is based on the respective Price Index. Income Return is the difference between the Total Return Index return and the Price Return Index return. Calendar year data from 1976-2021.

A bond’s starting yield is a strong indicator of future return. As demonstrated below, we map the 10-year U.S. Treasury yield with the future 10-year return of the Bloomberg U.S. Aggerate Bond Index (the “Index”). There is significant connection between yield and future return. In fact, since 1976, the 10-year U.S. Treasury yield and the future subsequent 10-year return of the Index had a 94 percent correlation.

Treasury Yields
Sources: FactSet, Morningstar Direct, Fiducient Advisors. For the time period January 1, 1976 to January 31, 2022.

Past, Present & Future

This is not the first time we have gone through a rate rising cycle. Since 1983 there have been seven rate rising cycles and as outlined below, markets have reacted differently in past periods. On average, the Index returned 3.9 percent during these rate rising periods. However, let us examine these time periods a bit more before we use this historical analog to quell our concern. As demonstrated above, yield is an important variable to future outcomes. The difference between today and the past is the average starting yield-to-worst was 6.7 percent. This gave fixed income investors a significant head start to positive outcomes.

Bloomberg U.S. Aggregate
Sources: Capital Group. Bloomberg Index Services Ltd., Morningstar. As of 10/31/21. Daily results for the index are not available prior to 1994. For those earlier periods, returns were calculated from the closest month-end to the day of the first hike through the closest month-end to the day of the final hike. Starting Yield to Worst sourced from FactSet and is taken from the start of the month in the period displayed.

Today, we do not have the same luxury. Yields are materially lower and moreover, the duration of the Index is higher than it has been in recent past. As a result, the Index is more sensitive to interest rate movement than in previous environments yet is offering investors less compensation in return for that risk.

Bloomberg U.S. Aggregate2
Source: FactSet. Data as of January 31, 2022.

Do bonds still have a place in my portfolio?

Yes! Fixed income has historically been a return generating and risk mitigating asset. Given the current level of interest rates and inflation, positive real returns are likely to be more difficult within high quality fixed income going forward. However, as a risk mitigating asset we believe it can still play an important role in a diversified allocation. Over the last 20 years, the Bloomberg U.S. Aggregate Bond Index has outperformed the S&P 500 100 percent of the time when the S&P 500 experienced a drawdown of three percent or more. Recent notable examples of this capital preservation benefit include the selloff in the spring of 2020 at the onset of the COVID-19 pandemic and the 2008 Global Financial Crisis. Having an allocation to core fixed income during these events helped protect portfolio assets.

Market Drawdowns
Source: Morningstar Direct. As of January 31, 2022.

What Now?

We are not proponents of market timing. We believe ardently in using a consistent framework to allocate to the right opportunities in portfolios over the long-term. With some notable headwinds facing fixed income including low current rates, longer duration and inflation – positive real returns within fixed income are likely to be challenged.

With that in mind, we list several approaches to consider. However, the appropriateness of any given strategy will depend on an investor’s individual circumstances and the following should not be taken as advice:

  1. Diversify a portfolio’s fixed income exposure away from traditional core fixed income. Dynamic bond strategies that allocate across the fixed income landscape can help insulate investors from potential rising rate scenarios. These strategies often have lower duration profiles compared to traditional core fixed income and may be able to take advantage of greater volatility in fixed income as a source or return.
  2. Credit Sensitive bonds, if constructed in a risk-conscious way can provide higher yields while minimizing the drawbacks of traditional fixed income. Such an allocation should be considered with broad portfolio objectives, high quality and risk constraints.
  3. All else equal, the best way to avoid potential headwinds in fixed income is to own less of it or consider shorter-term or inflation-linked bonds.  The various sectors of the bond market are much less correlated than equity sectors.   Investors with a thoughtful approach to risk management, a clear objective and the ability to do so should consider other asset classes or sectors of the bond market that add additional value over the long-term.

For more information, please reach out to any of the professionals at Trust Point.

Bloomberg U.S. Aggregate Index covers the U.S. investment grade fixed rate bond market, with index components for government
and corporate securities, mortgage pass-through securities, and asset-backed securities.
The S&P 500 is a capitalization-weighted index designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.
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Steve Brudos, Portfolio Manager