Fixed Income Outlook: Catching Summer Yield Waves

Bond market volatility increased toward the end of the quarter but remains below the levels witnessed during the first quarter of 2021. The largest increase this quarter occurred following the surprise change in the Federal Reserve (Fed) dot plots, projections that now indicate the potential for two rate hikes in 2023 — up from one previously.


This partial policy pivot flattened the yield curve by 23 basis points in June, the largest monthly flattening since 2015.1 Yet the flattening slowed toward the end of the month following Fed Chair Jay Powell’s declaration that the dot plots should be taken with a grain of salt2 — and they should be. For example, projections published in 2015 and 2016 forecasted interest rates rising much faster than the Fed conducted their hikes. And even after the Fed raised rates in December 2015, the projections continued to miss the mark — forecasting four hikes in 2016 even though there would be only one that year. Put simply, the dot plot is a projection of where officials feel policy may be in the future, not where it will be. So the rise in short-term rates that contributed to the flattening in June was likely a knee-jerk response that should mean revert.

The first change of the crisis-related policy decisions is likely to be a tapering of bond purchases. San Francisco Fed President Mary Daly, a voting member in the Federal Open Market Committee, said conditions could be met later this year or early next.3 And this aligns with the Fed’s view on labor, with Chair Powell indicating unemployment should noticeably improve by the fall4 — a forecast strengthened by the June payroll report that saw the pace of hiring accelerate by the most in 10 months.5 Tapering, or at least foreshadowing of the timeline for tapering, will likely place upward pressure on longer-term rates and steepen the yield curve over the coming months.

Irrespective of whether the Fed acts, we are likely to see rates rise modestly throughout the summer as economic data improves amid the recovery. Currently, 11 out of the 16 economic data points we track have improved past their pre-pandemic levels.6 One metric that is not above its pre-pandemic level, however, is consumer confidence. Yet the latest reading exceeded all forecasts and was propelled by Americans becoming more upbeat about the economy and the job market.7

This confidence should place more upward momentum on consumer spending, particularly within the services industries that are still not back to pre-pandemic levels. Given that consumption makes up roughly 70 percent of the economy, this should lead to continued upward-revised GDP figures and a potentially higher US 10-year yield — as it is a market proxy for forward-looking growth and inflation prospects.

Beyond rising rates, the recovery will also continue to create a supportive backdrop for credit (fewer defaults and more upgrades), even as yields and spreads are stretched within traditional fixed-rate segments — most notably high yield, where yields are now at a record low of 3.75 percent.8

The tight spreads and low yields create a weaker fundamental backstop if volatility does rise, however. And there is the potential for more bond market volatility, perhaps after the Federal Reserve Bank of Kansas City’s Jackson Hole Economic Policy Symposium in late August, which historically has been used to communicate major policy changes.9

Even if rates do rise, the level of yields will still be low from a historical perspective. And investors will have to navigate a sea of rate options that have either elevated duration risks or tight valuations. As a result, over the next quarter, investors may want to focus on duration management (shorter-duration corporates and more balanced active core mandates), as well as target less-stretched credit exposures (senior loans) that offer a noticeable yield pickup over basic Treasuries and core Bloomberg Barclays US Aggregate Bond Index (Agg) bonds.

Theme 1: Target Yield and Mitigate Rate Volatility With a Balanced Active Core
Given the outlook for potentially higher, but still historically low, rates and a possible increase in bond market volatility this summer from post-crisis policies likely kicked off at the Jackson Hole symposium, investors may want to reexamine their core allocations within bond portfolios. And with these market forces in play, active management may be more ideal than owning the broader Agg.

An active mandate has more flexibility and depth of options, two valuable traits in this market. An active strategy can alter the duration profile based on prevailing macro trends as well as target other bond sectors not included in the Agg, such as high yield bonds (3.74 percent), emerging-market bonds (3.8 percent), and bank loans (3.70 percent)10 — three sectors which offer some of the highest yields in the fixed income universe today.

An active strategy that simply overweights credit and doesn’t offer a balanced and risk-managed exposure may, however, be unable to provide the intended diversification that core bonds are meant to offer within the broader portfolio. The SPDR® DoubleLine® Total Return Tactical ETF (TOTL) seeks to generate high quality income by balancing both traditional and nontraditional fixed income asset classes.

As of the end of Q2, approximately 30 percent of TOTL’s portfolio was allocated to pure credit sectors, favoring securitized credit over corporate credit.11 And within the 70 percent allocated to more rate-sensitive markets, roughly 32 percent12 of it was to agency mortgage-backed securities — a core bond segment with an 83 basis point advantage over basic Treasuries.13

This ability to allocate differently across bond sectors has positively contributed to TOTL’s 101 basis point outperformance in 2021.14 Additionally, selection effects within those sectors have also been a positive contributor, combining with sector effects to make up just less than half of the outperformance from TOTL this year. The largest contributor, however, has been the duration management implemented by the portfolio management team — speaking to the multiple access points of flexibility an active mandate has at its disposal.

As a result of this flexibility, TOTL yields 100 basis points more than the Agg,15 but remains underweight duration (4.32 years vs. 6.61 years).16 And this focus on duration management could continue to be the key driver of performance in the core, as rates could remain choppy over the coming months due to uncertainty surrounding the global recovery, the transitory nature of inflation, and the pace and timing of central bank policy normalization.

Despite its exposure to nontraditional credit-sensitive sectors, TOTL can still potentially serve as a defensive core bond exposure. DoubleLine’s focus on risk management has allowed TOTL to defend against both equity and interest-rate volatility, as evidenced by lower historical drawdowns, as shown below.

TOTL Drawdown vs. Rates, Equities, and the Agg

TOTL also has a superior drawdown profile than its peers, as during the Fed rate hike in Q2 2015, TOTL saw a drawdown that was 126 basis points less than its median active peer.17 Likewise, during the pandemic-induced volatility seen at the end of Q1 2020, TOTL saw a drawdown that was 335 basis points less than that of its peers. In fact, TOTL ranks in the 7th percentile relative to its peers based on max drawdown since its inception.18 DoubleLine’s focus on active risk management and balancing of credit- and interest-rate-sensitive sectors has led TOTL to have a standard deviation that is lower than 98 percent of its peers since its inception.19

To mitigate potential equity and rate volatility in the core while targeting a higher level of income, consider going active with the SPDR DoubleLine Total Return Tactical ETF (TOTL).

Theme 2: Focus on Loans for Potential Upside and Income

Looking outside the Agg for income generation naturally leads to below-investment-grade credit strategies like high yield. However, the credit markets are, to a degree, priced to perfection given record low yields and elevated valuations (tight spreads) — creating a noticeably asymmetrical return profile, a fact reinforced by its negative convexity.20

Yet, while tight, the environment remains constructive for credit considering the accommodative monetary policies in place, improving corporate profits, and rebounding economic data. There are also positive rating trends. Upgrades are outpacing downgrades by a 2:1 ratio, and the default environment is improving — with JP Morgan forecasting declining defaults in 2021 and 2022.21

Below-investment-grade senior loans may be able to provide high income without the stretched valuations found within the traditional fixed-rate high yield market. Senior loans currently yield the same as high yield (3.7 percent vs. 3.74 percent), but have more upside potential based on the current average price in the market.22 Even with senior loans outperforming traditional high yield by 60 basis points this year, the average price has stayed below par ($98.08). Conversely, the average price of high yield bonds is over $104, as shown below. This dynamic for loans creates a similar high yielding exposure but with a less asymmetrical return profile than fixed-rate high yield .

Loan vs. High Yield Average Price

Beyond the improved valuations, senior loans also may offer a performance tailwind based on changes in interest rates. Fixed-rate credit, after all, is not immune to duration headwinds, as yield curve changes have subtracted 165 basis points from the overall 3.62 percent return in 2021 from high yield.23 Senior loans, however, have been able to sidestep any duration-induced price declines, as a result of its floating rate structure, while still participating in the credit rally. Yield curve changes so far this year have been negligible for loans, a fact underscored by loans not only outperforming fixed-rate high yield this year (+60 basis points), but also the more duration-sensitive investment-grade market (+455 basis points).24

The base rate of the floating rate component is usually one- to three-month LIBOR. Therefore, the duration for senior loans is usually between 30 and 90 days. Thus, concerns about inflation and the potential for interest rates to rise further based on the Fed’s latest projections may mean that the loan category — as a result of its lower duration — may hold its value more than other credit instruments. And if, as expected, the Fed raises rates to temper any inflationary headwinds — and short-term interest rates (LIBOR) increase — then the loan coupon also increases.

Should the credit rally come to a stall, however, loans are also more senior in their capital structure. Historically, they have witnessed lower relative levels of volatility than fixed-rate high yield (5.50 percent vs. 7.37 percent).25 This, combined with their high income profile, more upside potential relative to high yield -based pricing levels, and stronger ability to mitigate any increase in rates due to their floating rate structure, makes loans an integral part of a diversified credit portfolio in this current environment.

For an actively managed senior loan exposure that may add more value over an indexed approach through credit selection, consider the SPDR® Blackstone Senior Loan ETF (SRLN).

Theme 3: Trim Rate Risk Within Corporates

Within the investment-grade (IG) corporate bond market, rate movements have been the dominant driver of returns through the first six months of the year, subtracting 373 basis points of return.26 This negative impact from yield curve changes more than offsets the positive 270 basis points of return from spread tightening amid the rally27 — even as spreads fell to the anomalously low 1st percentile at 82 basis points.28

Credit spreads across the maturity spectrum are tight, with all tenors’ spreads below the bottom 5th historical percentile.29 While the recovery is still likely to be supportive to credit markets and further spread tightening, there is not much room left for spreads to tighten to a point where spread return contribution could overcome the impacts from likely higher interest rates. Particularly for broad-based corporate bonds that have an extended duration profile of over 8.5 years.30

Therefore, duration management within the core investment-grade corporate bond sector is important. The only drawback to trimming duration completely and focusing on shorter maturities would be sacrificing income. For example, the floating-rate investment-grade corporate note market (duration of 0.08 years) yields only 34 basis points,31 while one- to three-year corporate bonds yield only a slightly higher 57 basis points.32 Striking a balance between yield and duration, therefore, is crucial. Analyzing a maturity segment’s yield per unit of duration alongside current yield levels can be helpful in navigating this challenge.

The maturity segment, as shown below, with the highest yield per unit of duration ratios, and a yield over 1 percent, is the 1- to 10-year space. The overall profile is improved by simply “cutting off the tail” on the longer-duration bonds in the 10-year-plus maturity bucket. Compared to the broad market, the 1- to 10-year segment has 4.15 years less duration (48 percent lower), but a yield still north of 1.3 percent. While the latter is 32 percent less, it is not a one-for-one trade-off with duration which positively impacts the ratio. Similarly, by including the short end of the curve, the 1- to 10-year segment has a slightly stronger ratio than the 5- to 10-year space, given the latter’s higher yield is offset by a longer duration (two more years) than the 1- to 10-year market.

IG Bond Market Yield and Duration Profiles

Beyond the potential benefits if rates do rise, the 1- to 10-year space may also be slightly less impacted by a rise in credit spreads off these low levels on a relative basis versus broad corporates. The option-adjusted spread duration (OASD), a metric that indicates the percent change in the price of a bond with respect to a 100 basis point change in spreads for 1- to 10-year corporates, is 4.5 versus 8.5 for broad corporates.33

Both levels are stretched versus history, but the broader market’s OASD is at an all-time high (99th percentile) right now, whereas the 1- to 10-year space has a bit more room to go before hitting its own historical max (sits in the 94th percentile).34 The duration times spread (DTS) for the 1- to 10-year corporate market is also less than the broader corporate bond segment,35 further indicating less credit volatility and perhaps tempering some concerns, on a relative basis, of owning tightly valued broad corporates.

For a shorter-duration investment-grade exposure, consider the SPDR® Portfolio Intermediate Term Corporate Bond ETF (SPIB).

Appendix

TOTL, SRLN, SPIB Standard Performance