Manage Yield and Duration in the Hunt for Total Return

With hawkish central banks continuing to push rates higher to fight inflation, core bonds look to post back-to-back calendar year losses for the first time ever.¹ And as credit spreads widened amid sluggish growth and heightened volatility, taking on credit risk also led to losses in 2022.

On the positive side, aggressive rate hikes from the Federal Reserve (Fed) and other global central banks have resulted in a great rate reset that has dislodged the bond market from a low-rate, near-zero yield era. With the amount of negative yielding debt falling by 85%,² bond investors now have numerous attractive yield opportunities on the short-end of the curve.

These opportunities are, however, predicated on the continuation of higher rates. And although markets are projecting rates to decline by late 2023, central banks are likely to remain plenty aggressive in the near term.

Until the Fed’s battle against inflation turns less aggressive, the elevated yields in defensive short-duration sectors may help investors balance income and total return in order to preserve capital. Meanwhile, tightening monetary policy and mixed fundamentals reinforce the case for core active strategies.

For Rates, More of the Same, Most of the Time

When the October inflation data came in below expectations, Fed officials stressed that they need to see sustained easing of pricing pressures before pausing the Fed’s aggressive policy stance.³ Accordingly, beyond what was done in 2022, the markets expect the Fed to raise rates by another 50 basis points (bps) in December, followed by 25 bps hikes at the first two 2023 meetings in February and March. In fact, hiking could continue through June,⁴ after which rates are expected to fall, as shown in the following chart.

If the Fed follows through on its comments, the fed funds rate could be 4.50% by its first 2023 meeting — the highest level since 2007.⁵ The fed funds rate sets the tone for the broader rate market. For instance, the US 2-year yield historically trades at a 36 bps premium to the fed funds rate, but it now trades at a 33 bps premium.⁶ This means:

• The US 2-year yield could start 2023 at 4.86%, if the average relationship holds
• The market does not expect the Fed to become more aggressive right away, given that the current premium is in line with the historical average

Interestingly, throughout 2022 the premium averaged 126-bps,⁷ as the forward-looking nature of the market more rapidly priced in the central bank’s aggressiveness ahead of its meetings and policy decisions.

For now, whether it's a surprising inflation print or continued forward guidance from Fed officials to expect stepped-down, non-jumbo hikes, it’s doubtful the US 2-year yield will get as far ahead of the fed funds rate in 2023 as it did in 2022.

Nevertheless, a 4.86% US 2-year yield to start 2023 would be the highest since 2007.⁸ Another impact would be the derivative effect further Fed tightening has on the yield curve.

Looking ahead, it's highly unlikely that the current -52 bps inversion between the US 2-year and the US 10-year yield will remain that negative. In fact, we think the US 10-year likely will rise faster than the US 2-year as the Fed continues rate hikes, given that we are at the deepest inversion since 1980. Further, the Fed signaling stepped-down rate hikes could possibly be viewed as growth positive and lead to a steepening of the curve that leaves it less inverted.

What’s the upshot for bond portfolios if we see more of what we saw in 2022 for most of 2023? Core bonds with over six years of duration are likely to once again post duration-induced price declines. Meanwhile, shorter-duration segments may offer more attractive yield and total return prospects as result of less rate risk.

Be Cautious on Credit When Reaching for Yield

Reaching for returns with high yield bonds in 2022 was met with a double-digit dose of negativity, as high yield has posted a -13% loss to date.⁹ Despite the sizable negative return, credit spreads are not constructive. In fact, single-B rated and double-B rated, as well as broad high yield, all have spreads well below their 20-year averages.¹⁰

For broad high yield, current spreads are 10% below their long-term average and close to the 70th percentile — a level that doesn’t necessarily scream value, despite the weak returns.¹¹ Part of this is that high yield spreads began 2022 in the low 300 bps range. This continued lack of fundamental flexibility is a major reason why investors may want to be cautious on credit.

Ratings sentiment has not been this negative since the start of the COVID-19 pandemic. High yield bonds have had twice as many downgrades as upgrades over the past two quarters.¹² The trend is also unfavorable, as the upgrade-to-downgrade ratio fell in every quarter of 2022.¹³

This weak sentiment is likely to extend to defaults. Trailing 12-month defaults on a par-weighted basis are projected to increase from 1.3% to 6.0% over the next 12 months — well above their historical 3.3% median.¹⁴

This uptick coincides with lower growth from high yield issuers that mirrors the sluggish earnings picture for US equities. More than 75% of the publicly-listed high yield issuers that published earnings results through mid-November revealed an EBITDA decline of 3.3% from the prior quarter.¹⁵ Revenues and margins also declined, underscoring the challenging fundamental environment for 2023.¹⁶

The yield for high yield is very attractive, however. The yield to worst on broad US high yield bonds now hovers around 9%, above the 20-year historical average.¹⁷ Yet, this is more of a function of the elevated rate market, as spreads are still tight.

When viewed relative to US investment-grade corporate bonds, however, the yield differential of high yield is 331 bps, tighter than the long-term historical average of 370 bps.¹⁸ This indicates that investment-grade corporate bonds have a slightly more relative attractive yield profile (absolute level is 5.6%)¹⁹ given the many fundamental risks in the market.

Subpar returns that saw 65% of the headline figure reduced by duration effects,²⁰ weak ratings sentiment, dour fundamentals, sluggish growth, and more attractive yield opportunities elsewhere mean a cautious outlook for below investment-grade credit. Yet, if this weakness manifests in an environment that pushes spread levels above historical averages, there could be periods to consider tactically overweighting high yield in 2023.

Working to manage the risks of tightening monetary policy that may give way to a policy pause, alongside mixed fundamentals in the new year, reinforces the case for core active strategies. By combining traditional and non-traditional fixed income asset classes with the goal of maximizing total return over a full market cycle, active sector allocation and security selection may be able to better defend against rate and credit risk than core aggregate bonds.

Shorten-Duration for Yield and Total Return

Higher rates have created attractive defensive yield opportunities on the short end of the curve —namely Treasurys with less than one-year of maturity given the recent inversion of the 3-month and 10-year yield spread. An aggressive Fed and the likelihood for more rate hikes to come mean yields on 3-12 month T-bills are now higher than those of all different tenors. And given the maturity band, the rate risk for this exposure is minimal, as shown in the following chart.

As a result, this portion of the curve represents a potentially attractive trade-off compared to the 1-3 year Treasury market, the closest portion of the curve with a similar yield (3-12 month T-bills have a higher yield-per-unit-of-duration). Only 1-3 month T-bills have a better yield-per-unit-of-duration profile, but their yield is still below 4%.

The lack of duration from this defensive tenor has also limited 2022’s duration induced price declines (+0.29% versus 1-3 year Treasurys’ -4.80% year-to-date return)²¹ and could continue to do so if the Fed follows through on its hawkish rhetoric.

The 1-3 year US investment-grade corporate bond segment — yielding over 5.3%, a level not seen since the Global Financial Crisis (GFC)²² — also has witnessed an increase in relative attractiveness. Rates have moved so swiftly that the sector’s yields are 250 bps above their 20-year average.²³ Duration has remained steady and now sits at 1.95 years, on par with its 20-year average,²⁴ and while rates have changed, the term structure has not.

As a result of the rise in yields, but stasis rate risk, 1-3 year corporates’ yield-per-unit-of-duration is 2.6, 78% above its long-term average and in the 99^th percentile post-GFC.²⁵ Not all portions of the credit curve, however, have witnessed the same beneficial rise in their yield-per-unit-of-duration, a by-product of the currently inverted yield curve. Of the five segments shown in the following chart, only 1-3 year corporates saw a significant rise in yield-per-unit-of-duration.

Given that credit spreads are below their long-term average (86 bps versus 110 bps), but right at their post-GFC average of 82 bps, the extra yield is not a result of outsized credit risk, which is a potential benefit given the mixed fundamentals.²⁶

As a result, the 1-3 year investment-grade space, a segment carrying an index-weighted average rating of A3/BAA1,²⁷ represents a high-quality value opportunity to pick up a yield that is on par with the US equity market earnings yield (5.1%)²⁸ and above that of the broader US aggregate bond market (4.7%),²⁹ without taking on any more duration or credit risk than one would have assumed over the past 20 years in this portion of the credit market.