For us, the value proposition for core bonds (as defined by the bonds within the Bloomberg
Aggregate Bond index) is that they tend to provide potential for liquidity, diversification (to
potentially counter equity market risk), and positive total returns to portfolios. Unfortunately,
none of those values are 100% certain all the time. Like all markets, fixed income investing
involves risks and at times, negative returns. However, despite the historically poor start to the
year, the value proposition for core bonds has actually improved recently. Investing is a
forward-looking exercise, and with the back up in yields already taking place this year, we
believe now could be as good as it’s been in quite some time for core bonds.
Importantly, yields are moving higher because of the expectations of higher short-term interest
rates and not an increase in credit risk. Coming into the year, markets were only expecting one
or two short-term interest rate hikes by the Federal Reserve (Fed) this year with most of the
hikes expected to come in 2023. However, markets have aggressively re-priced the number of
expected Fed rate hikes and now expect as many as 11. As such, the yield on the 10-year
Treasury security has doubled this year after increasing around 100 basis points (1.00%) off its
lows in 2020. The 260 basis point (2.6%) move higher that has already taken place this cycle
is the biggest move higher in yields since 1994, when rates moved higher by 280 basis
points—and that was at the end of the rate hiking cycle. With so many rate hikes priced in at
this point, we think the worst is behind us.
So have rates peaked? Historically, rates have tended to move a lot before the first rate hike,
(like they’ve already done this year) but they still move marginally higher throughout the rate
hiking process and don’t actually make a top until the Fed stops raising rates. This cycle has
only really just started. That doesn’t mean we will see significantly higher yields—we don’t
think we will—but we could see 3.25-3.35% on the 10-year this year, which would likely be the
top in yields for this cycle, in our view. However, we still expect yields to trade in a range
between 2.75-3.0% for most of the year and then fall slightly from current levels throughout the
year with the 10-year Treasury yield ending the year around 2.5%. So, as mentioned, we have
seen a big move higher in rates this year but we do think the worst is behind us.
NO MORE TINA?
TINA, or “there is no alternative,” has been a big reason diversified asset allocation portfolios
have been overly geared towards equities over the past few years. The relative attractiveness
of equities over fixed income was undeniable when interest rates were hovering around all time lows. Now interest rates have moved higher recently, though the relative attractiveness between the two broad asset classes is much more balanced (albeit still leaning favorable
towards equities by at least one measure as we explain in this blog found here).
But, for investors unwilling or uninterested in taking on additional equity risks, there are a
number of fixed income markets with yields trading above long-term averages. As seen in
Figure 1, the yield-to-worst on most fixed income asset classes is hovering around the highest
yields we’ve seen in a decade. And for the Bloomberg Aggregate index, which is the broad
based core bond index, outside of two months in 2018, yields are the highest they’ve been
since 2010. Since starting yield levels have been a good predictor of future returns (see
below), with yields increasing meaningfully this year, future returns look more attractive than
they have in years. With interest rates so low over the past few years, the back-up in yields
could be an attractive opportunity for suitable income-oriented investors. And while we can’t
guarantee that interest rates won’t go higher, at current yields, the risk/reward for owning fixed
income has improved, in our opinion.
As mentioned, for many fixed income asset classes, starting yield levels have been an
accurate predictor of future returns. Bonds, for the most part, are unique in their structures in
that, absent defaults, expected returns are largely determined by starting yields. That is, we
tend to have a pretty good idea what to expect out of many fixed income instruments over time
because coupon and principal payments are known in advance and contractually obligated. As
such, whether you’re invested in an individual bond, an investment that tracks an index like the
Bloomberg Aggregate index, [Figure 2] or a strategy designed to actively outperform an index,
returns are largely predicated on starting yields. And this is true if you hold the fixed income
instrument to maturity (for an individual bond) or at least five years (for a portfolio of bonds)
regardless of what interest rates do in the interim. That is, if you buy and hold a fixed income
investment, the short-term volatility you experience due to changing interest rate expectations
is just volatility. It has very little bearing on the actual total return if held to maturity (or if held to
the average maturity of a portfolio of bonds).
DIVERSIFICATION BENEFITS OF BONDS MAY BE IMPROVING
Since 2000, the correlation between stocks and bonds has generally been negative, although
there has been considerable variation with that relationship. And at times, the relationship
between stocks and bonds has, in fact, been positive (from 1965 to 2000, correlation was
actually slightly positive due to higher inflation and more frequent inflationary shocks). So, the
historical correlation between stocks and bonds is actually close to zero—meaning it’s
generally noisy. In other words, it isn’t that uncommon to see equity and bond prices moving
lower (or higher) at the same time.
However, now that interest rates have moved off the all-time lows set back in August 2020,
there is more of a cushion to act like a diversifier during equity market drawdowns, which is
what we’ve seen during the most recent equity market stresses over the past few weeks. Since
the start of May, equities are down over 6% whereas core bonds are positive. And without any
additional macroeconomic shocks driving the divergent returns, it’s comforting to see bonds
providing that equity buffer, albeit over a very short time horizon. The back-up in yields this
year has certainly been painful, but the ability for fixed income to act as an equity buffer has
increased, in our view. As bond and equity markets both move past the aggressive repricing of
Fed rate hikes that have caused both markets to sell off this year and grapple with a potential
slowdown in economic growth, bonds have the potential to mitigate the risk in portfolios again
as we move through the year.
CONCLUSION
Core bonds have been a staple in diversified asset allocations. However, with returns as
negative as they’ve been this year, investors may be undergoing a rethink of the utility of core
bonds. We think that may be a mistake. We still think the value proposition for core bonds
remains. Liquidity, equity diversification, and total returns are all valuable properties core
bonds bring to diversified portfolios—and each of those value propositions have improved
recently. Moreover, bonds are unique in their structures in that coupon and principal payments
are, for the most part, guaranteed (unless the issuer defaults) and the primary factors of long term total returns. The price volatility we’ve seen so far this year doesn’t impact those payments. And with yields higher in many markets, now may be a good time for suitable
investors to start looking at additional investment opportunities within fixed income.
IMPORTANT DISCLOSURES
This material is for general information only and is not intended to provide specific advice or recommendations for any
individual. There is no assurance that the view s or strategies discussed are suitable for all investors or w ill yield positive
outcomes. Investing involves risks including possible loss of principal. Any economic forecasts set forth may not develop as
predicted and are subject to change.
References to markets, asset classes, and sectors are generally regarding the corresponding market index. Indexes are
unmanaged statistical composites and cannot be invested into directly. Index performance is not indicative of the performance
of any investment and do not reflect fees, expenses, or sales charges. All performance referenced is historical and is no
guarantee of future results.
Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and
bonds are subject to availability and change in price.
There is no guarantee that a diversified portfolio w ill enhance overall returns or outperform a non-diversified portfolio.
Diversification does not protect against market risk.
Any company names noted herein are for educational purposes only and not an indication of trading intent or a solicitation of
their products or services. LPL Financial doesn’t provide research on individual equities.
All information is believed to be f rom reliable sources; how ever, LPL Financial makes no representation as to its completeness
or accuracy.
US Treasuries may be considered “safe haven” investments but do carry some degree of risk including interest rate, credit,
and market risk. Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values w ill decline as interest
rates rise and bonds are subject to availability and change in price.
The Bloomberg Aggregate U.S. Bond Index represents securities that are SEC-registered, taxable, and dollar denominated.
The 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 Standard & Poor’s 500 Index (S&P500) is a capitalization-weighted index of 500 stocks designed to measure performance
of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major
industries.
All index data from FactSet.