Limit Duration in Pursuit of Real Income
Bond markets have never recorded back-to-back calendar years of negative total returns. But if bonds do not rally by more than 10% through the end of the year, we will make history.
This potentially historic year will be marked by the most aggressive monetary policy tightening since 1994, as the Federal Reserve (Fed) and other global central banks seek to quell record levels of inflation. For perspective, when the Fed Funds rate increased by 250 basis points (bps) in 1994, the Bloomberg US Aggregate Bond Index (Agg) fell by 3%, but 9.5% on a price return basis.1
Today, market forecasts call for eight more rate hikes this year, with an implied policy rate greater than 2.8% by yearend.2 And with recent hawkish Fed rhetoric indicating a low margin of error for these prognostications — it’s clear that higher rates are ahead.
Therefore, it’s important to reevaluate your bond allocation to mitigate the negative impact of rising rates. This means limiting duration in pursuit of real income by targeting floating rate exposures and ultra-short active strategies.
Hawks Talk the Talk, Now Ready to Walk the Walk
In May, Chairman Jay Powell delivered a harsh message to investors that “until inflation comes down in a clear and convincing way, we [the Fed] will keep pushing, and if that means moving past understood levels of “neutral,” we won’t hesitate to do that.”3 Currently, a 50 bps hike is projected in both the June and July meetings.4
That means a high probability for higher rates, and, therefore, lower bond returns for the rest of the year. From a rates perspective, there is historically a 34 bps difference between the Fed Funds rate and the US 2-year yield (the portion of the yield curve that is highly sensitive to Fed policy).5
Extrapolating this historical premium to the Fed Funds rate and the forecasted implied rate mentioned above, the US 2-year yield could be 3.14% by yearend, compared to 2.68% today.6 If that were the yield at the end of the year, short duration bonds, as measured by the Bloomberg US 1-5 Year Government/Credit Float Adjusted Index, could potentially fall another 1%, based on the change in yield (+0.40%) and the current duration of that exposure (2.7 years).7
Rate hikes are not the only policy actions pressuring rates. The market will soon have to contend with quantitative tightening (QT). The Fed has foreshadowed a $95 billion a month QT pace that could be gradually phased in ($60 billion in Treasuries)8 and total $1 trillion a year. And once QT starts, it will likely put upward pressure on long-term rates — a potential trend already reflected in rising term premiums.9 While this should mitigate any curve inversions, it doesn’t mean we will see a steepening trend. In fact, the spread difference is likely to remain tight and the curve flat — with both short- and long-term rates moving higher, but at different speeds.
Notably, today’s higher rates for broad core bonds are still below inflation expectations (3.55% versus 4.02% for the US 2-year breakeven rate),10 signaling negative expected returns for both core bonds and their real yields.
Bottom line: expect higher rates and continued weak core bond returns. After all, forward guidance is the third tool monetary policymakers can use to impact the rates market, in addition to rate hikes/cuts and balance sheet management. And right now, the Fed’s forward guidance is crystal clear — higher rates are on the horizon until inflation is under control. That’s a message bond investors cannot afford to miss.
Float with Investment-Grade Bonds
Duration on core fixed income has increased significantly over the years. At its current level of 6.5 years, it has 50% greater rate risk than the last time the Fed tightened policy in a similarly severe manner in 1994.11
Core bonds’ extended level of duration presents significant challenges as rates rise. To put this in perspective, if the yield on the Agg were to increase by 60 bps over the next two quarters, essentially a third of what it has increased in the first two quarters,12 the Agg could fall an additional 4% based on its current duration level and add to its already double-digit 2022 decline.
Given this backdrop, duration management within the core takes on paramount importance. Yet, just trimming duration by focusing on short-term bonds is a blunt approach. Rather, using different fixed income strategies, both active and indexed, in the core investment-grade market may allow you to trim duration while still retaining some yield upside.
Investment-grade floating rate notes could offer an indexed-based, macro sector solution. Unlike fixed rate bonds, floating rate bonds are less sensitive to an increases in rates, given that they pay a variable (i.e., floating) coupon rate, based on prevailing short-term market rates, plus a fixed spread.
As a result of the quarterly coupon resets, floating rate bonds’ duration profile is structurally low. It currently sits at 0.06 years,13 which is in stark contrast to the broader Agg’s 6.5 years or the 2.7 years for a fixed-rate exposure of the same maturity band.14 This floating rate profile leads to a significantly more attractive yield-per-unit-of-duration profile (31.0) versus other short-term exposures that could be considered in order to trim duration (e.g., 1-3 year Treasuries are 1.4), as shown in the following chart.
Yield per Unit of Duration: Investment-Grade Bond Markets
Past rising rate periods illustrate how floating rate securities may behave during this new rate regime. For example, in the last rising rate environment from late 2015 through the end of 2018, when the Fed Funds rate rose from 25 to 250 bps, investment-grade floating rate notes had positive monthly performance in 33 of the 37 months (90%), and the yield increased from 91 to 361 bps.15 A fixed rate exposure of the same maturity had positive returns in just 23 of 37 months.16
In fact, since 2003 investment-grade floating rate notes (+0.23%), on average, have outperformed short duration government (-0.13%) and corporate bonds (0.01%) as well as the Bloomberg US Aggregate Bond Index (-26%) during months when the 2-year Treasury yield increased. And in 86% of those months, returns were positive — more than double the percentage of positive returns for the Agg.17
Based on their structure, floating rate notes are a pure play, but investors seeking to mitigate the effects of a new rate regime can also consider the ultra-short duration market. For further yield enhancement and depth of sector coverage in the ultra-short category, an actively managed ultra-short strategy, can also allocate to high yield corporates and securitized credits (asset-backed securities, mortgage-backed securities, and commercial mortgage-backed securities) in addition to investment-grade debt. Beyond the expanded sector reach, the credit selection and risk management process also could add to total return and yield.
Add Structurally Low Duration High Income
Even though rates have risen, the yield on core aggregate bonds is still structurally low following years of coordinated low interest rate global monetary policies. For perspective, the Agg’s current 3.5% yield is nearly half of its 6.31% long-term average.18
The larger challenge, however, is that the core bond yields are not only structurally nominally low, but low and negative on a real basis. Examining the current rate on the Agg less year-over-year CPI, as well as compared to inflation expectations, provides both a look at real yields with inflation in arrears and on a forward-looking basis.
With this analysis, it is clear that right now the potential income earned from traditional core bonds is unable to keep up with historic elevated levels of inflation. As a result, even if bond price returns were flat for the rest of the year (a zero return), the expected real return, driven by income, would still be negative.
Given these dynamics, investors must target credit instruments that have a yield above inflation expectations. As shown in the following chart, this doesn’t leave many options. The inflation-adjusted yield, as illustrated, uses the current nominal yield and subtracts the expected inflation rate over the next two years, as a proxy for the impact of the current inflationary regime.
Bond Market Inflation-Adjusted Yield Opportunities
Based on this analysis, senior loans, preferreds, emerging market local debt (EMD), and US high yield are the only segments with a positive inflation-adjusted yield, as well as a positive inflation-adjusted yield per unit of duration, a calculation used to measure a breakeven rate of return versus rate risk.
Given this data, and a less than sanguine view of EM prospects as a result of the elevated geopolitical and currency risk, high yield and senior loans are stronger options. And even with the broader drawdown in risk assets this year, credit sentiment remains conducive.
Ratings continue to be decisively skewed toward upgrades and not downgrades, as evidenced by upgrades surpassing downgrades for six consecutive quarters now.19 Overall corporate default rates are also expected to be well below historical averages over the next 12 months (1.5% versus 4.1%).20 High yield corporate bond spreads are also above the long-term median (448 bps versus 453 bps),21 and can no longer be considered stretched — mitigating the fundamental concerns earlier in the year around tight valuations.
Senior loans’ floating rate structure may also prove to be even more valuable should rate hikes impact the short end of the curve. This has been on display already this year, as loans are outperforming the Agg by 7.4% year to date.22
In addition to mitigating any potential duration-induced return headwinds, loans’ floating rate component increases the potential yield as the securities’ underlying coupons adjust to the prevailing short-term market rate they are tied to.
Overall, loans’ potential to generate high income and their floating rate structure can possibly reduce the negative impact of higher rates, making loans an integral part of a diversified credit portfolio in this environment. Either a pure senior loan strategy or a multi-credit high income strategy that uses floating rate loans, floating rate collateralized loan obligations (CLOs), along with high yield, may benefit investors searching for real income without adding significant duration risks.
Implementation Ideas
For strategies that help limit duration risks in the pursuit of real income, consider:
Ultra-short duration investment-grade strategies, including one that’s actively managed
Low duration, high income active mandates