With the recent activity in interest rates, many investors are busy rebalancing their portfolios while also keeping a close eye on recession indicators.
- Recent aggressive rate hike cycles have led to curve inversions, which is sign of turbulent financial conditions.
- Investors looking to get into fixed income have a broad range of choices as yields have stretched higher across the fixed income spectrum.
- Investors need to establish which bond categories can help them rebalance their portfolio.
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Aggressive rate hike cycles across major global markets have led to curve inversions – a sign of somewhat turbulent wider financial conditions meaning market participants face an unusually challenging economic and financial environment.
Twelve months ago, common wisdom held that investment-grade corporate debt was barely worth a thought because yields were so low. Now that story has changed – short-dated yields particularly have climbed quickly over the past year.
With this activity in interest rates and the spread between the U.S. 2-year/10-year tipping negative, many investors are rebalancing portfolios, while keeping a close eye on these recession indicators.
Broad range of choices in fixed income
Investors looking to get into fixed income have a broad range of choices – optionality is strong; it’s not just about T-Bills. Yields have stretched higher across the fixed income spectrum – from developed markets’ sovereign bonds to investment-grade, high-yield to emerging markets. Even municipal bonds are delivering value in this segment.
In almost all of these areas we’re now seeing rates well above where they were last year. Bonds thus can provide an opportunity to capture available income and provide some padding to portfolios on a total return; when yields begin to deflate, this points to markets deflating – and that includes equities.
Chart 1: Yields across fixed income markets
This may prompt the everyday investor to consider the place of fixed income in their portfolio.
Chart 2: S&P 500 earnings yield vs U.S. 6-month T-bill yield
Finding yield in fixed income
Yield is the common language shared by both bond and equity investors (see chart 2).
Investors might choose equity risk over corporate debt risk for its higher return probability; however short-term funding rates can now offer the same – if not higher – results than the S&P 500 when compared to its earnings yield (inverse of the P/E ratio): around 4.5%.
With the boom in outsourced trading, it’s also becoming easier for investors seeking to gain exposure to fixed income than ever before. Access to institutional grade liquidity is now quicker and less costly.
Until a year ago, much of the global bond market was offering yields below 1% with negative yields mixed in (see chart 3).
Chart 3: 10Y government yields – U.S., UK, Germany, Italy, Japan
Owing to the underperformance of the equity market over the last year, multi-asset portfolios or historically equity-only funds have had an interesting time navigating through this environment.
The S&P 500 earnings yield raises a pertinent question: into which part of the capital structure do investors feel more comfortable putting their dollars?
Those wanting to invest in a safer segment of the capital structure may need to identify which bond categories can help them to rebalance – an endeavour in which BondCliQ may be especially helpful, given its depth of insights into U.S. corporate bond activity.
This needn’t be a permanent shift in one’s investment thesis – taking on short-dated notes exposure can be a temporary measure which, again, thanks to outsourced trading, is not difficult to do.
Bracing the changing economic cycle
What goes up, must come down (see the longer timeseries view in chart 4). From one month to the next, policymakers face challenges including inflation and shocks to the system such as the collapse of Silicon Valley Bank (SVB) (SIVB.O) and, more recently, the run on First Republic Bank (FRC.N).
Although the economic outlook remains uncertain, experts and the market are pricing in a slowdown, after 14 months of hikes. No surprises from the latest Fed announcement (benchmark rate to a range between 5% and 5.25%). Can we expect to see a pause at the June 14th FOMC meeting?
So when and where will a recession happen first? We’ll need to keep following the flight paths of doves and hawks through this season. There’s also a sleeping giant to watch out for – Japan. The timing and decision by the BoJ to end YCC (yield curve control) could reshape global trade dominance.
To help brace the changing economic cycle, exposure to bonds with yields above historical averages today that can be sold later to realise a total return can offset losses expected in the equity market. This is relatively new territory – such protection hasn’t been available for nearly a decade.
Chart 4: U.S. inflation – actual vs forecast & 10Y UST yield
Which way are U.S. corporate bond yields moving?
Taking a closer look at U.S. credit, the following visual (chart 5) from BondCliQ provides a view as to how corporate bond yields are moving. Spliced out by their ratings, one might see much higher yield among distressed debt (B/CCC) – but you would need the stomach to ride that volatility and default probability.
Of course, there’s the trickiness of managing a portfolio and managing liquidity – you’re likely to see bids, but can you expect to see the offer? Assets are still being retained as corporates have preferred to extend maturities rather than raise new debt at these rates. In some cases, we’ve seen BBBs yield higher than BBs – it’s a thin landscape out there.
Chart 5: Average 5Y yield by rating, U.S. corporate bonds
When it comes to default probability, the U.S. debt ceiling showdown will continue to stress markets into the summer. We’re seeing signs of that reflected in spreads widening for Credit Default Swaps on U.S. debt. What is risk-free these days?
If we live through another downgrade on the U.S., we can be sure the fixed income landscape will evolve even further. With the various macro factors in play, investors across the spectrum are trying to predict when we will see a change in the shape of this cycle. Maybe this is the calm before the storm – volatility (.VIX) remains oddly subdued. Is the market ignoring a recession or has it already been priced in?
*FTSE Indices used as follows: Euro IG: EuroBIG®, World IG: WorldBIG®, UK IG: UKBIG US IG: USBIG®; Euro HY: FTSE Euro High-Yield Bond Index, Work HY: FTSE World High-Yield Bond Index, US HY: FTSE US High-Yield Market Index, EM China: FTSE Broad Diversified China, EM Diversified: FTSE EM Government Bond Index (EMGBI), EM IG: FTSE Global Diversified IG, EM HY: FTSE Global Diversified HY.
