Bond Compass

Bond Market Outlook: Positioning Portfolios Amid Higher Yields

Aggressive rate hikes from the Federal Reserve (Fed) and other global central banks have reset rates, dislodging the bond market from a low-rate, near-zero yield era. With negative yielding debt falling from $15 trillion at the start of 2022 to $0,1 bond investors now have plenty of new yield opportunities.


Q1 2023

Head of SPDR Americas Research

As the Fed continues to battle inflation, defensive — and now higher yielding — short-duration sectors and diversified active core mandates can help investors balance income, total return, and principal preservation. And if the 2022 headwind of a strong US dollar (USD) recedes, emerging market (EM) local debt could also help investors boost yield, without reaching down the credit spectrum.

Follow the Fed for Signals, but Don’t Chase Yield Noise

The market expects the Fed to raise rates by 25 basis points (bps) at the first two meetings of the year, in February and March, and then to continue hiking through June,after which rates are expected to fall. But with the latest Fed minutes setting the median dot plot figure for 2023 at 5.125%, and seven FOMC members indicating even higher rates,3 a pause in rates is more likely than a decline. This would allow the Fed to gauge how its hikes are working their way through the real economy.

If the Fed follows through on the market’s initial expectation, the fed funds rate could be 4.75% after the Fed’s first 2023 meeting — the highest level since 2007.4 And, the fed funds rate sets the tone for the broader rate market. For example, the US 2-year yield historically trades at a 36 bps premium to the fed funds rate. This means the US-2 year yield could be around 5.11% after the Fed’s first meeting — 65 bps higher than what it is now.

While quite the spike for Q1 2023, there is some room for mean reversion, as the US 2-year had been trading 40 bps above the fed funds in mid-December but didn’t budge after the December meeting. A 5.11% US 2-year yield would be the highest since 2007.5

As the Fed continues to tighten, it’s highly unlikely that the current -72 bps inversion between the US 2-year and US 10-year yield will remain so negative. In fact, we expect the US 10-year will rise faster than the US 2-year as the Fed continues to hike, given this is the deepest inversion since 1980.6 Pauses signaled by the Fed could be viewed as growth positive and lead to a steepening of the curve that makes it less inverted.

Finally, macro uncertainty means investors may want to be cautious on credit. Yes, the 8.7% yield for high yield is very attractive.7 But why chase yields with asymmetric risks (weak growth, rising default expectations, weak ratings sentiment alongside below average spreads)8 when cash-like bonds and higher-quality shorter-duration yields are around 5%?9

What does all of this mean for your fixed income portfolios? How should you position for a new yield era in 2023? Consider these three strategies:

Implementation Idea #1: Seek Value in a High-Quality Approach to Short-Duration Markets

Higher rates have created attractive defensive yield opportunities on the short end of the curve, beyond Treasurys and T-bills. And more rate hikes ahead mean yields are likely to rise further. Yet, given the maturity band, the rate risk for shorter-duration bonds is minimal. This means duration-induced price declines should be minimal — as evidenced by bonds under three years of maturity posting returns of -3.72% in 2022 versus the broader bond market’s double-digit decline.10

1-3 year US investment-grade corporate bonds now yield over 5.3%, a level not seen since the Global Financial Crisis (GFC).11 Rates have moved so swiftly that the sector’s yields are 250 bps above their 20-year average.12 But duration has remained steady and now sits at 1.95 years, on par with its 20-year average.13

1-3 year corporates’ yield-per-unit-of-duration is 2.6, 78% above its long-term average and in the 99th percentile post-GFC.14 But not all portions of the credit curve have witnessed the same beneficial rise in their yield-per-unit-of-duration, a byproduct of the currently inverted yield curve, as shown below.

With credit spreads below their long-term average (80 bps versus 110 bps), but at their post-GFC average of 82 bps, the extra yield is not a result of outsized credit risk, a potential benefit given the mixed fundamentals within the credit spectrum (more downgrades than upgrades, and weak earnings growth).15

As a result, the 1-3 year investment-grade space, a segment carrying an index-weighted average rating of A3/BAA1,16 represents a high-quality value opportunity to pick up a yield on par with the US equity market earnings yield (5.2%)17 and above that of the broader US aggregate bond market (4.6%),18 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. The low-cost indexed SPDR® Portfolio Short Term Corporate Bond ETF (SPSB) provides exposure to this slice of the bond market.

Beyond that beta building block, an active ultra-short strategy can access other attractive segments of the shorter-duration market. Think securitized credits, like asset-backed securities, mortgage-backed securities (MBS), and commercial mortgage-backed securities. The credit selection and risk management of an active approach also could be additive from a total return perspective.

The actively managed SPDR® SSGA Ultra Short Term Bond ETF (ULST) invests at least 80% of its net assets in a diversified portfolio of US dollar-denominated investment-grade fixed income securities, including up to 10% in high yield. The fund targets a duration of 1 year or less and a weighted average maturity of 2.5 years or less.

This means ULST currently offers a similar yield to the broader Agg, but with 88% less volatility over the past year, as shown below. ULST also produced a positive return in 2022 (+0.84%), outperforming its peer group median manager by 70 bps. This maturity focus, income potential, and volatility profile relative to the broader market may again be beneficial in 2023.

Implementation Idea #2: Diversify Core Fixed Income with Active to Combat Headwinds

Managing the risks of tightening monetary policy alongside mixed fundamentals and a potential recession underscores the case for core active strategies. In this environment it’s limiting to confine the core of a portfolio to Agg-based strategies. It’s also risky, given the prospect for higher rates ahead and how duration effects drove negative returns in 2022.

Active strategies can tailor a portfolio’s duration and sector allocations in a more flexible, market-aware fashion. Active duration management, sector allocations, and security selection may be able to better defend against rate and credit risks than indexed core Agg bonds, given that rate volatility is in the 87th percentile over the past five years19 and high implied credit volatility is in the 82nd percentile over past five years.20

The SPDR® DoubleLine® Total Return Tactical ETF (TOTL) combines top down active risk management with bottom-up security selection and seeks to deliver high-quality income, while exploiting the inefficiencies within the global bond market. Part of the top-down process includes combining rate-sensitive traditional credit and non-traditional bond sectors, while tactically managing an embedded mortgage bias.

This approach led to strong returns in 2022 as TOTL navigated a tumultuous market better than most of its peers. The fund ranked in the 17th percentile within its Morningstar Intermediate Core-Plus peer group last year,21 outperforming its benchmark (the Agg) by 95 bps and its peer group median by 148 bps.22 Also, TOTL’s alpha never turned negative in 2022, as shown below.

TOTL’s 2022 track record didn’t come from outsized risk bets; the fund’s information ratio (excess returns over excess volatility) ranked in the 13th percentile among its peer group.23 The fund also didn’t overweight illiquid non-traditional markets; 72% of TOTL’s portfolio was allocated to investment-grade bonds.24

Implementation Idea #3: Look to Emerging Market Local Debt for Elevated Yields

The USD’s strength hurt many markets in 2022, chief among them EM local debt. Last year, the segment posted its worst calendar year return ever (-12% ),25 pushing the yield on EM local debt to 6.3% — nearly 300 bps above global aggregate bonds — even though EM local debt has an average A3/BAA1 investment-grade rating.26

While a shift higher in yields from central bank policy actions detracted from returns, currency effects were the main culprit. As the USD strengthened in 2022, EM currencies fell. Historically, EM local debt returns have had a 94% correlation to the returns on EM currencies, so this trend is no surprise.27

In fact, since 2008, EM local debt has had negative returns in 92% of the months when EM currencies fell (and the dollar strengthened), with an average monthly loss of -2.29%.28 As a result, an allocation to EM local debt is not so much a bullish view on the debt from developing nations as it is a bearish view on the USD.

High US inflation, rising US rates, and safe demand have kept the USD well-bid and trading at 20-year highs. Yet, given where we are from a valuation perspective, some near-term mean reversion could occur, particularly if a dip in inflation figures prompts the Fed to indicate a pause in rate hikes is likely in 2023. That would be a positive for risk-asset sentiment and could reduce demand on the safe haven USD.

A softening USD would be net positive for EM local debt, since in the months when EM currencies rallied, EM local debt’s return was positive 86% of the time with an average monthly gain of +2.27%, as shown in the previous chart. And due to demoralizing returns, an allocation to EM local debt now offers a generationally attractive yield that may just be worth the risk.

To implement a bearish view on the USD, consider the SPDR® Bloomberg Emerging Markets Local Bond ETF (EBND).

ULST Standard Performance as of December 31, 2022

 

YTD

1 Year

3 Year

5 Year

10 Year

NAV

0.84

0.84

0.87

1.54

0.00

Market Value

0.87

0.87

0.86

1.56

0.00

Source: Ssga.com, as of December 31, 2022. Inception date: October 9, 2013. Gross Expense Ratio: 0.2%. Past performance is not a reliable indicator of future performance. Investment return and principal value will fluctuate, so you may have a gain or loss when shares are sold. Current performance may be higher or lower than that quoted. All results are historical and assume the reinvestment of dividends and capital gains. Visit ssga.com for most recent month-end performance. Performance is shown net of fees. Performance returns for periods of less than one year are not annualized. The market price used to calculate the Market Value return is the midpoint between the highest bid and the lowest offer on the exchange on which the shares of the Fund are listed for trading, as of the time that the Fund's NAV is calculated. If you trade your shares at another time, your return may differ.

TOTL Standard Performance as of December 31, 2022

 

YTD

1 Year

3 Year

5 Year

10 Year

NAV

-12.06

-12.06

-3.17

-0.52

0.00

Market Value

-11.59

-11.59

-3.22

-0.47

0.00

Source: Ssga.com, as of December 31, 2022. Inception date: February 23, 2015. Gross Expense Ratio: 0.55%. Past performance is not a reliable indicator of future performance. Investment return and principal value will fluctuate, so you may have a gain or loss when shares are sold. Current performance may be higher or lower than that quoted. All results are historical and assume the reinvestment of dividends and capital gains. Visit ssga.com for most recent month-end performance. Performance is shown net of fees. Performance returns for periods of less than one year are not annualized. The market price used to calculate the Market Value return is the midpoint between the highest bid and the lowest offer on the exchange on which the shares of the Fund are listed for trading, as of the time that the Fund's NAV is calculated. If you trade your shares at another time, your return may differ.


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