Bonds Now Offer Yield and Value
The Federal Reserve’s aggressive monetary tightening has pushed bond yields to levels not seen in 15 years. Gone are the low-to-zero interest rates that empowered risk taking and fueled stock returns. As the environment shifts from there is no alternative (TINA) to stocks to what I’ll call the return of bonds (ROB), short-term investment-grade corporates offer both yield and value.
Bonds Are Back, With Elevated Yields
The Bloomberg US Aggregate Bond Index’s (Agg) jump from 2.5% in March 2022 to over 4.5% doesn’t fully reflect just how elevated yields are historically.1
Across major bond markets, before the sizeable banking crisis risk-off move, yields were in the upper 90th percentile over the past 15 years — with some in the 99th, as shown below. Even below investment-grade credit sectors have historically high yields (74th percentile) and without the financial distress that usually coincides with elevated yields. That’s because corporate spreads are currently below long-term averages.
For example, below investment-grade yields were 19% in 2008 compared to 8.7% today. But spreads were 1,660 basis points compared to 480 basis points today. The lack of impact from spreads on elevated yields for credit illustrates how the Fed’s aggressive policy has reverberated throughout the bond market and set the table for the rest of the market.
In fact, almost all of the segments shown have yields well above their 30-year average. High yield’s current yield-to-worst is on par with its 30-year average, while emerging market debt is just below, as spreads are not wide in that market either. Short-term bond segments have the largest difference to historical averages.
Rising Rates, Higher Returns
All else equal, today’s higher rates should lead to equivalent returns, as there is a 94% correlation between a bond’s prevailing yield and the subsequent three-year return.2 While this relationship can break down in the short term, the correlation increases over time.
The five-year return has a 97% correlation to the yield at the start of the holding period, as shown below. This trend prevails across market segments; more than 100% of high yield’s return (4.8%) over the past decade is a from coupons (6.9%), not price changes (-2.1%).3
Bonds' Attractive Relative Value
Stocks have not rerated like bonds, and valuations for US equities remain above historical averages, as shown below. Price-to-book valuations are 30% greater than the 15-year average.
Stretched valuations for stocks alongside elevated yields on bonds have impacted the equity risk premium (ERP), which is the earnings yield on the S&P 500 Index less the yield-to-worst on the US 10-year bond. The current 5.6% earnings yield and the US 10-year yield of 3.4% lead to a difference of 2.20% — below the historical median of 3.16%. And when the ERP is below the median, subsequent 10-year annualized returns for equities are 3.11% compared to 11% when the ERP is above the median or 5.5% on average.
Short-term Investment-grade Corporates: Yield and Value
The current environment makes 1-3 year US investment-grade corporate bonds — now yielding over 5.5%, more than 300 basis points above their 30-year average — particularly attractive.4
While rates have risen for 1-3 year investment-grade corporate bonds, duration has remained steady at 1.95 years, on par with its 30-year average.5 As a result of the rise in yields, but stasis in rate risk, 1-3 year corporates yield-per-unit-of-duration is 2.6. That’s 78% above its long-term average and in the 99th percentile for the post-Global Financial Crisis period.6 And with credit spreads near their long-term average, the extra yield doesn’t come from outsized credit risk.
As a result, the 1-3 year investment-grade segment, with an index-weighted average rating of A3/BAA1, represents a high-quality value opportunity to pick up a yield on par with the US equity market earnings yield of 5.6% and above the broader US Aggregate bond market’s yield of 4.5% — without taking on any more duration or credit risk than you would have assumed over the past 30 years in this portion of the credit market. The volatility profile of 85% is 52% less than that of broad stocks and bonds.7
To invest in this segment of the bond market, consider the low-cost indexed SPDR® Portfolio Short Term Corporate Bond ETF (SPSB).
Explore more developing market trends and download our latest outlook on the bond market.