October 22, 2018
Brian Rehling, CFA , Co-Head of Global Fixed Income Strategy
Short-Term Pain for Longer-Term Gain
- As U.S. bond yields rise, fixed-income investors may be feeling some “short-term pain” as they review recent performance.
- Yet, bonds held to maturity typically have positive returns (barring a credit event or default). Further, rising rates can offer fixed-income investors the potential for “long-term gain” by raising coupon levels and returns in the long term.
What it May Mean for Investors
- We recommend that investors remain well-diversified; favor shorter-term securities over longer-term issues; and move up in credit quality.
- A bond ladder or active management often can help fixed-income investors to capitalize upon rising interest rates more effectively.1
Many fixed-income investors have focused on the recent interest-rate increase and the potential for further yield increases (and rightfully so). Year-to-date (YTD) performance in fixed-income markets has been poor, almost across the board. As of October 12, the Bloomberg Barclays U.S. Aggregate Bond Index2 had a total YTD return of -2.05%. For longer-term U.S. bonds, the index performance has been even worse, as the Bloomberg Barclays U.S. Aggregate 10+ Year Bond Index had a total YTD return of -6.83%. But higher rates are not all bad for fixed-income investors. First, an investor who holds a bond to maturity will continue to receive their expected cash flow (unless there is a credit event or default). Second, the recent U.S. yield increase should help to push future yields higher for fixed-income investors.
Yields tell a story
Fixed-income investors have long been attracted to yield, because “yield” typically is a good proxy for cash flow—which is precisely what investors are seeking to generate sustainable income for living expenses or other funding needs. But beyond simple cash-flow needs, the prevailing yield in high-quality fixed income also has another use for investors; it historically has been quite good at predicting total return performance over longer time periods. This is especially true of high-quality fixed income classes.
Using Bloomberg Barclays U.S. Aggregate Bond Index data starting with its inception in 1976, we analyzed its total return over a period of years—and how much of that return could be forecasted by the prevailing yield level. Over the past 40 years, the current yield was a very strong indicator of future returns for the Bloomberg Barclays U.S. Aggregate Bond Index. We found the strongest correlation to the initial yield level was near the five-year average total return of this index. Other factors may contribute to an understanding of yield and return; thus, this analysis may not be indicative of future results (and multiple factors need to be considered when assessing yield and return analysis).
The average variation between the initial yield and the ensuing annualized five-year, total return is just 0.37% since the inception of the Bloomberg Barclays U.S. Aggregate Index in 1976. The yield of the investment-grade, taxable holdings in the Bloomberg Barclays U.S. Aggregate Index was 3.57% on October 15, 2018. This represented an increase from a yield low of 1.61% in September 2012 and just 2.55% a year ago. We believe that the recent yield increase should add to future fixed-income returns for taxable investment-grade issues overall. Based on this yield model alone, we believe that investors in a well-diversified, investment-grade, taxable bond portfolio may experience low single-digit average yearly total return over the next five years. Let’s look at this analysis visually in Chart 1.
Predictably, the relationship between yield and total return loses its strong historical correlation as one moves down in credit quality. Thus, we would not suggest that investors use a similar model in the high-yield debt class. The higher default rates inherent in lower-credit-quality securities have pushed five-year total returns below current yields during most periods (historically). As of October 12, 2018, the Bloomberg Barclays U.S. Corporate High Yield Index yielded 6.58%.
Our analysis implies that investors in investment-grade debt may potentially experience modest, but positive, total returns overall in the near term (barring a credit event or default). Yield tells a story, and its relevance to performance is significant.
While return expectations should be set relatively low for taxable investment-grade debt going forward, owning bonds in a portfolio should not be all about return. Fixed-income holdings can play an important role in many portfolios, by providing an investor with diversification, by lowering volatility, and by providing liquidity.
Both recent and longer-term history has shown that high-yield allocations have the potential to be far more volatile than traditional investment-grade security holdings. We currently have an unfavorable view of the high-yield debt class, and we suggest investors avoid the temptation to “reach for yield” as valuations are relatively expensive in the below-investment-grade space. We recommend moving up in credit quality within the high-yield universe and in fixed-income portfolios overall.
Additional yield increases in the future may lead to short-term pain for investors’ fixed-income portfolios (particularly relating to market-price trends at the index or individual security level). But investors should remember that, over time, that pain could be turned into investment gains as those higher yields can help boost future coupon (and overall bond) returns. In summary:
- We recommend maintaining duration at levels below individually-selected benchmarks in fixed-income portfolios, given the relatively flat Treasury yield curve and our expectation for modestly higher interest rates.3
- We remain unfavorable on the high-yield debt class, given expensive valuation and an asymmetric risk/return profile.
- In our view, investors should look for opportunities to move up in credit quality and focus on maintaining a well-diversified portfolio that is not overly concentrated in any one name, sector, or asset class. It is important to remember that diversification does not guarantee investment returns or eliminate risk of loss.