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Market Outlook

Seek Income and Balance Risks with Bond ETFs

2023 Midyear ETF Market Outlook

Risks within the bond market are unbalanced right now, with implied volatility in the 90th percentile and realized volatility at 35-year highs.1 Credit fundamentals are also asymmetric, as spreads are below long-term averages while rating trends are poor. And default rates are expected to be between 3% and 4% over the next 12 months2 — higher than in 2021, 2022, and the three years prior to the pandemic.

Still, despite these risks, bonds are inherently more attractive than stocks right now. That’s because stretched stock valuations and elevated bond yields have tightened the equity risk premium (ERP) below its historical median.

Given the current bond market volatility and fundamentals, how can investors extract the most value from bonds? It’s all about balancing the risks.

Investors should consider:

  • Ultra-short and short maturity markets that offer greater yields than broad core bonds, but with far less volatility.
  • Mortgage-backed securities (MBS) that offer a better balance between yield and duration than US Treasurys for any defensive duration trades.
  • Active core exposures and selective credit strategies to position for evolving monetary policy and mixed fundamentals.

Elevated Bond Volatility Is Likely to Persist

Federal Reserve (Fed) policymakers have indicated they will take a wait and see approach from meeting to meeting,3 with some keeping an “open mind” on whether further rate hikes are needed.4 But traders are forecasting a higher probability of rate cuts, with the first potentially occurring as early as the third quarter.5

These opposing views have added to already elevated bond volatility. The 90-day realized volatility of the Bloomberg US Aggregate Bond Index (Agg) is back over 8% and in the 97th percentile — above readings during the Great Financial Crisis and the onset of COVID-19.

In other corners of the bond market, long-term US Treasurys’ standard deviation of returns is over 17.53%6 — more than the volatility of returns on the S&P 500 Index over the last 90 days (15.82%).7 Long-term Treasurys are now 171 basis points more volatile than stocks, when typically stocks are 480 basis points more volatile than long-term US Treasurys.

Given the attention investors are likely to give incoming economic data as they seek to forecast the Fed’s next move, bond volatility will likely remain elevated. We expect day-over-day performance during major data releases to continue to be outsized, as it was when the Q1 GDP report in late April sparked four straight days of a greater than 50 basis point daily return move for US Treasurys.8

In fact, outsized daily moves have occurred all year, as investors waited for a Fed pause. On more than 30% of the days so far this year, US Treasurys have moved up or down by more than 50 basis points.9 That’s more than the 27% of days in 2022 when bonds fell double digits (the most in more than 30 years), and far greater than the 8% calendar year average.

In Credit, Fundamental Risks Signal Caution

Despite the 4.5% return so far this year,10 fundamentals are signalling caution as valuations based on credit spreads are not overly attractive. For high yield, spreads sit 7% below their historical 20-year average (481 versus 519).11

Within subjective credits, only CCC-rated and below issuers have spreads above historical averages, as BB- and B-rated credits sit 9% and 2% inside their 20-year averages, respectively.12 Sector spread decomposition reveals the same trend, as 18 out of 20 high yield sectors have spreads below their historical averages. The average differential is -120 basis points below the 20-year average.13

But tight valuations are not backed by robust fundamental strength. Q1 earnings growth for high yield issuers was negative and the interest coverage ratio, while elevated to history, has now declined for ten consecutive weeks and is well off its peak.14 This has been driven largely by the sequential decline in earnings before interest, taxes, depreciation and amortization (EBTIDA) growth, where the trailing 12-month percent change has declined every month since April 2022.15

Ratings actions and default expectations add to the uneven sentiment for high yield, as downgrades have outpaced upgrades for four consecutive quarters.16 Default rates have also ticked higher, increasing from 0.6% on a par weighted basis in May of last year to 2.1% today.17 Forecasts indicate default rates could be between 3% and 4% over the next 12 months.18

Relative Value? Favor Bonds Over Equities

Across major bond markets, yields now hover around the 80th percentile over the past 20 years, as shown in the following chart.19 Even below-investment-grade credit sectors have yields in the 77th percentile, without the severe financial distress that usually coincides with elevated yields.

Bonds Now Offer Higher Yields (and Value) Across the Globe

Stretched valuations for stocks, alongside these elevated yields on bonds, have impacted the ERP, calculated as the earnings yield on the S&P 500 Index less the yield to worst on the US 10-year bond.

The current 5.39% earnings yield and 3.44% US 10-year yield lead to a difference of 1.95% — below the historical median of 3.16%. And when the ERP is below the median, subsequent 10-year annualized equity returns are 3.11% compared to 11.00% when the ERP is above the median or 5.50% on average.20

This dynamic, along with the attractive yields on bonds, mean the relative value of bonds is greater than stocks.

And the risks within today’s bond markets are not without the potential for higher returns.

Today’s higher rates should lead to equivalent constructive absolute returns, as there is a 94% correlation between a bond’s prevailing yield and the subsequent three-year return.21 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.22

How to Balance Risks as You Seek Income and Total Return

Owning high quality, uncorrelated assets can help defend portfolios against losses during periods of rate and equity volatility as you pursue return opportunities. Consider:

Active Core Bond Strategies

Today’s uncertain monetary policy path and mixed fundamentals call for active fixed income ETFs to potentially insulate your core bond portfolio from elevated volatility, while also pursuing return opportunities.

By combining traditional and non-traditional fixed income asset classes to maximize total return over a full market cycle, active sector allocation and security selection may better defend against rate and credit risk than core aggregate bonds can.

Short-Term Bonds

Beyond the core, short-term bonds’ maturity focus, income potential, and volatility profile relative to the broader market may allow investors to strike a better balance between risk and return — particularly for US 1-3 year corporate bonds.

US 1-3 year corporate bonds now yield over 5% and have duration and spread levels in line with 20-year averages.23 As a result, this high-income opportunity can be targeted without taking on any more duration or credit risk than you would have assumed over the past 20 years.

Not to mention their return volatility profile is 86%, 55%, and 70% less than that of broad stocks, bonds, and credit markets, respectively.24 And as shown in the following chart, relative to other bond segments, US 1-3 year corporate bonds have the highest yield-per-unit-of-volatility ratio.

Ultra-Short Bonds and Mortgages

An active ultra-short strategy can access other attractive segments such as securitized credits, like asset-backed securities, mortgage-backed securities (MBS), and commercial mortgage-backed securities all at once.

As a defensive bond sector with a low correlation to stocks,25 mortgages may allow you to selectively add duration at a yield in excess of US Treasurys. And if the Fed does cut rates toward the end of the year, mortgage rates could fall and reignite refinancing,26 which has troughed, bringing in duration on mortgages.

With MBS durations at record highs (6.2 years), any decline in duration could offer price appreciation in addition to the 4.4% yield.27 For example, the last time MBS duration was over 5.5 years in 2018, the sector returned 9.0% over the next year, as duration fell to roughly 3 years amid increased refinancing activity.28

Active High Income

With yields in the upper 77th percentile,29 high yield offers a potentially attractive long-term entry point for income-minded investors, despite the risks.

To navigate this market where fundamental volatility (uneven earnings trends) is colliding with elevated rate volatility, consider an actively managed credit strategy. A high income strategy that uses both security and sector selection may help you incrementally add high yield positions with an eye toward risk.

Implementation Ideas

For strategies that help manage duration risks in the pursuit of income, consider:

Active total return core mandates with a history of defensive positioning to manage elevated bond uncertainty

Low duration, investment-grade strategies with attractive yield-per-unit-of- duration and volatility profiles

Core defensive sectors to extend duration where it may be better compensated from a price and income perspective than US Treasurys

Selective credit strategies to seek yield while navigating asymmetric credit and rate risks


Bio Image of Michael W Arone

Michael W Arone, CFA

Chief Investment Strategist

Bio Image of Matthew J Bartolini

Matthew J Bartolini, CFA, CAIA

Head of SPDR Americas Research


Bio Image of Anqi Dong

Anqi Dong, CFA, CAIA

Senior Research Strategist

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