2021 Midyear Market Outlook

Favor Bonds Less Impacted by Rising Rates

Fueled by expectations for higher growth and inflation, consensus economic estimates are for the US 10-year yield to surpass 1.8% by the end of the year and reach 2% by Q2 2022.1 And if growth does accelerate amid the reopening, policymakers will likely begin tapering bond purchases, possibly sending yields higher.2

Yet, while rates may be rising, they remain low for core bonds from a historical perspective, meaning that generating income is a challenge. And if rates do rise to meet the consensus forecasts, the duration induced price declines could present total return headwinds as well.

In this environment, targeting more growth-oriented bond sectors that are less impacted by rising rates may help you navigate a bond market distorted by the pandemic as well as impacted by the reopening’s reflation regime shift.

Lower Exposure to Asymmetrical Treasuries

Since the 1980s, traditional core aggregate bond returns have declined over subsequent decades. In the 1980s, the Bloomberg Barclays US Aggregate Bond Index (Agg) returned a cumulative 223%. The Agg’s return then fell to 110% in the 1990s, 85% in the 2000s, and 44% in the 2010s. Seventeen months into the 2020s, the Agg is up just 4.25%.3

The Agg’s current 1.58% yield — in the bottom third percentile historically — suggests more downside than upside, given that growth and inflation dynamics are putting upward pressure on rates. Even if rates rise only to 2% a year from now, the return on the Agg, forecasted based on a risk model, would be -1.51% due to its extended duration profile.4 If rates retest pre-COVID levels (2.34%), the loss could extend to -3.34%.5

The Agg’s 6.5-year duration stems from its 40% allocation to US Treasuries, a sector that will likely be a drag on current returns for core bonds due to its highly asymmetrical yield and duration profile. Yet, core bonds cannot be abandoned completely since owning a credit only portfolio curtails some of the potential diversification of bonds. Therefore, investors may want to consider removing Treasuries and owning mortgage-backed securities (MBS) as a defensive core option to decrease rate risk while preserving a low correlation to equities.

Year to date, MBS are outperforming the Agg and Treasuries, by 2.97% and 2.06%, respectively.6 This outperformance during a rising rate period is not confined to 2021. Over the past 30 years, when the US 10-year yield has increased month over month, the average monthly return on MBS has been -0.40% versus -0.60% for US Treasuries7 — underscoring the sector’s lower sensitivity to rate movements. In fact, the return on MBS is also greater than investment-grade (IG) credit (-0.54%) — the other major bond segment in the Agg.8

From a portfolio construction perspective, MBS yield more than US Treasuries (1.79% versus 0.99%),9 have a lower standard deviation of returns (2.09% versus 4.05%),10 and more importantly, a lower duration (4.2 versus 6.9 years).11 As shown below, this current optimal profile of a stronger yield per unit of duration has been persistent. And with a negative correlation to stocks (-23%),12 MBS still preserve some of core bonds’ diversification benefits.

Yield per Unit of Duration: Mortgage-Backed Securities versus Treasuries versus the Agg versus Investment-Grade Corporates

Target High Income/Less Rate-Sensitive Credit

While MBS may increase yield in the core, the level of income produced is still low overall. And while looking outside the Agg for income generation naturally leads to credit exposures, the credit markets are, to a degree, priced to perfection and represent an asymmetrical return profile as well.

Yields for IG credit, broad high yield, or different rating bands are all historically in the bottom decile. And in some cases, the yields are the lowest on record. These spreads, yields, and the average bond price in the broader categories paint a picture of tight credit markets:

  • IG credit: Yield (2.23%, 3rd percentile), Spread (87 basis points, 6th percentile), Average bond price (109, 86th percentile)13
  • Broad high yield: Yield (4.15%, 1st percentile), Spread (301 basis points, 6th percentile), Average bond price (104, 94th percentile)14

While tight, the environment for credit remains constructive given accommodative monetary policies, improving corporate profits, and rebounding economic data. Yet, as within the core, managing duration risk alongside credit sensitivities is important. And IG credit has posted a -4.14% return in 2021,15 even as credit spreads have declined, with yield curve changes accounting for more than 100% of that decline (-5.5%).16

High yield credit is also not immune to duration headwinds, as yield curve changes have subtracted 145 percentage points from the overall 1.92% return in 2021.17 One high income sector — senior loans — has been able to sidestep duration-induced price declines as a result of its floating rate structure, while still participating in the credit rally. So far this year, senior loans are up 2.4%.18

Because the base rate of the floating rate component is usually one to three-month LIBOR, the duration for senior loans is usually between 30 to 90 days. Thus, concerns about inflation and the potential for interest rates to rise further (as the consensus has forecasted) may mean the loan category — as a result of its lower duration — may hold its value more than other credit instruments. And, if the Federal Reserve raises rates to temper any inflationary headwinds — and short-term interest rates (LIBOR) increase — then the loan coupon also increases.

Due to these structural traits, senior loans have outperformed the broader Agg for 12 out of the last 13 consecutive months during this reflation rally.19 High yield bonds have had a similar performance trend versus the Agg. However, while the average price of high yield bonds has climbed, the average price on senior loans remains well below par ($97.79)20 — indicating further potential upside price appreciation from a continuation in this credit rally for loans relative to high yield.

This shorter duration does not detract from the relative income potential. Senior loans have a similar yield to fixed rate high yield deb (3.73% vs 4.15%).21 And if the credit rally stalls, loans are more senior in their capital structure, historically witnessing lower relative levels of volatility (5.6% vs 7.4%).22 Loans’ high income, low duration, low relative volatility profile compared to other segments is shown below.

Bond Sector Yields and Risk Profiles

Look Beyond the Traditional for Income

To target income opportunities, close to 4% in the satellite sleeves, preferred securities, and high yield municipal bonds are two more non-traditional sectors for you to explore.

High yield municipal bonds (HYM) have already been less impacted by the rise in rates so far this year — outperforming traditional IG corporates by 7.63% and high yield corporates by 1.58%.23 A government generally issues high yield bonds to pay for projects with undefined or uncertain revenue. These revenue bonds tend to offer higher yields as compensation for the risk and uncertainty associated with the project’s revenue stream. And because municipal bonds’ income is generally exempt from federal income taxes, the after-tax yield is also advantageous.

The current yield-to-worst on HYM is 2.82%24 while high yield corporates yield 4.15% pre-tax, but 2.62% post-tax.25 And income from high yield municipals is generated with lower volatility than both high yield corporates and large-cap dividend equities (8.38% versus 9.02% versus 17.90%).26 High yield municipals are also less correlated to equities than corporate investment-grade and high yield bonds (16% versus 34% and 77%, respectively),27 leading to a potential source of higher income generation without any additional equity risk. With less correlation to traditional core Agg bonds than US IG corporates (53% versus 82%),28 high yield municipals also offer an attractive risk/reward payoff in the current reflationary environment.

Political tailwinds also support high yield municipal bonds. The $362 billion dedicated to shoring up state and local balance sheets from the $1.9 trillion American Rescue Plan Act of 2021 may alleviate any concerns of increased default risk among high yield municipal bond issuers since the bill permits governments to use federal dollars to replace revenue lost due to the pandemic.29 Not to mention, the risk of default may continue to decrease as the broader economy reopens and economic growth improves.

If you are seeking higher income, you may also want to consider preferred securities. The current yield-to-maturity on preferreds — primarily investment-grade rated issuers is 4.66%, which is 308 and 243 percentage points higher than the broader Agg and IG Credit, respectively.31 Moreover, with duration sitting at 5.45 years, preferreds offer a strong yield per unit of duration (0.84 versus 0.23 and 0.26, respectively).32

Income may be generated without taking on excess volatility or sizable equity risk as well, thereby preserving some of the diversification benefits. As a hybrid, preferreds have balanced equity and bond correlations (56% and 43%, respectively), with significantly lower correlation to equities than high yield (77%).33 Preferreds’ lower volatility than both high yield and equities (6.9% versus 7.7% and 14.9%)34 can lead to more attractive yield per unit of volatility measures as well.

Beyond these structural benefits, there are some potential tailwinds as a result of the underlying composition of the exposure. Roughly 70% of the preferreds market is made up of issuers from the Financials sector.34 The Financials sector, as discussed in one of our other themes, is a favored market. The industry is expected to post earnings growth of 43% in 2021, almost double the estimate of 25% at the start of the year.35

Implementation Ideas

With potential for long-term rates to move higher, you may need to manage duration risks and avoid loading up on plain vanilla credit given the tight markets. 

 Consider mortgages to better balance yield and duration in the core:

Consider actively managed senior loans as a high income/low duration credit strategy:

Consider the high income potential from non-traditional bond sectors that offer attractive yield per unit of volatility metrics without elevated equity risk: