The Federal Reserve (the Fed) raised rates in March and the market expects nine more hikes for 2022, including multiple increases of 50 basis points.1 If the Fed meets these expectations, this would lead to an implied Fed Funds Rate of 2.60%.2 For comparison, at the end of the first quarter, the US 10-year yield was 2.4%.3
It would also mark 2022 as the tightest year for monetary policy since 1994 when the Fed Funds Rate increased by 250 basis points and the Bloomberg US Aggregate Bond Index (Agg) fell by 3%, but 9.5% on a price return basis.4
The Fed will also begin to shrink its balance sheet. In 2017, the bank began selling $10 billion in bonds a month and increased that to as much as $30 billion.5 Amounts could be higher this time, given the increased size of the Fed’s balance sheet. In fact, the Fed has foreshadowed phasing in a $95 billion a month pace ($60 billion in Treasuries)6 that could total $1 trillion a year in quantitative tightening (QT).
Higher Rates and Lower Returns Creates a Conundrum
From a rates perspective, there is historically a 34-basis point differential between the Fed Funds Rate and the US-2 year yield (the portion of the yield curve that is highly sensitive to Federal Reserve policy).7 Currently , the US 2-year yield is 200 basis points above the Fed Funds Rate (98th percentile),8 as the market has likely gotten a bit ahead of the Fed given its significant amount of forward guidance.
Source: Bloomberg Finance L.P., as of April 6, 2022. Past performance is not a reliable indicator if future results. Characteristics are as of the date indicated and are subject to change.
If we extrapolate this historical premium to the Fed Funds Rate, the US-2 year yield could be 2.94% by year’s end, compared to 2.54% today.9 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 Index, could fall another 1%, based on the change in yield (+0.40%) and their current duration (2.7 years).10
Meanwhile, today’s higher rates for broad core bonds are still below inflation expectations (3.11% versus 3.4% for the US 5-year breakeven rate),11 signaling that both expected returns for core bonds and their real yields are negative.
The high probability of negative returns, both on a price and income basis, presents the challenge of structuring bond portfolios to provide traditional diversification without significant duration induced price declines.
At the same time, macro risk has increased due to the lingering effects of the pandemic, the Russia-Ukraine war, and a looming mid-term election that will soon be on everyone’s radar. Plus, currency, oil, equity and bond volatility all registered above the 80th percentile heading into the second quarter12 — and the broader macro risk index is also in the 80th percentile.13
Given the negative impact rising rates can have on your bond portfolio, consider these three strategies:
1. Trim duration in the core while retaining yield upside
Duration on core fixed income has increased significantly over the years, reaching an all-time high of 6.78 years during the first quarter before ending at 6.6 years at quarter end.14 As a result, bonds currently have the highest amount of rate risk than ever before. In fact, bonds have 50% more rate risk than the last time the Fed tightened policy in 1994.15
Core bonds’ extended duration will present significant challenges as rates rise. To put this in perspective, if the yield on the Agg were to increase by 45 basis points over the next three quarters, a third of what it increased in the first quarter,16 the Agg could fall an additional 3% based on its current duration.
Yet, trimming duration by focusing only on short-term bonds is a blunt approach. Utilizing different fixed income strategies, both active and indexed, in the core investment-grade market may allow you to trim duration while retaining some yield upside.
Investment-grade floating rate notes are one option. Unlike fixed rate bonds, floating rate bonds are less sensitive to an increase in rates because 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, the duration profile is historically and structurally low (0.06 years currently),17 a stark difference to the broader Agg (6.6 years) or a fixed rate exposure of the same maturity band (2.7 years).18 This floating rate profile leads to a significantly more attractive yield-per-unit of duration (20.6) versus other short-term exposures that could be considered to trim duration (e.g., 1-3 year Treasury at 1.3), as shown below.
Yield-Per-Unit of Duration: Investment-Grade Bond Markets
In the last rising rate environment from late 2015 through 2018, as the Fed Funds Rate rose from 25 to 250 basis points, investment-grade floating rate notes had positive monthly performance in 33 out of 37 months (90%), and the yield increased from 91 to 361 basis points.19 A fixed rate exposure of the same maturity had positive returns in just 23 out of 37 months.20
Floating rate notes are a pure play, based on their structure, for investors seeking to mitigate the effects of a new rate regime. You also might consider an actively managed ultra-short strategy that, in addition to IG debt, allocates to high yield corporates as well as securitized credits (ABS, MBS, CMBS). Beyond the expanded sector reach, the credit selection and risk management process could be additive from a total return and yield perspective.
These two options in the ultra-short market can assist in trimming duration but they are unlikely to be used as a large core position to anchor the portfolio. Rather, they are more strategic tilts given market dynamics.
For a portfolio anchor, consider focusing on core active strategies that have a history of being underweight duration as a risk management tool. An active core manager also can access sectors such as collateralized loan obligations and non-agency mortgage-backed securities, beyond the Agg’s focus — on Treasuries, IG Corporates and Mortgages.
2. Seek high income solutions with lower duration risks
Even though the 117-basis point increase in the Agg’s yield during the first quarter was a near six standard deviation event,23 rates on core aggregate bonds are still structurally low following years of coordinated low interest rate global monetary policies. For perspective, the current 3% yield on the Agg is half of its long-term average (6.31%).24
The larger challenge, however, is that the core bond yields are low and negative, both on a structural and real basis. The current rate on the Agg less year-over-year CPI is -4.95% and when compared to inflation expectations using the US 5-year breakeven rate, the current rate is -0.51%.25 The potential income earned from traditional core bonds is not keeping up with historic inflation highs.
Based on the CPI measure, real yields have never been this low. And given that the latest CPI prints have yet to include the full impacts from the Russia-Ukraine war, CPI figures may continue to trend higher.
Investors should target credit instruments that have a yield above inflation.
Bond Market Inflation Adjusted Yield Opportunities
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 which is used to measure a breakeven rate of return versus rate risk.
Notably the inflation adjusted yield per unit of duration for EMD is a bit deceiving because currency risk is a larger driver of returns than duration.26 And with currency risk elevated (91st percentile) as a result of the Russia-Ukraine war,27 slowdown concerns in China stemming from lingering pandemic effects and weak corporate earnings sentiment, EMD’s real yield potential may not be worth the risk. This makes high yield and senior loans stronger options.
The credit environment remains constructive as well. For five consecutive quarters, ratings have been decisively skewed toward upgrades and not downgrades. In fact, in 2021, the ratio (1.94) of upgrades-to-downgrades was the highest in the last 10 years.28 Default rates are also expected to be well below historical averages over the next 12 months (1.7% versus 4.1%).29 Combine this positive ratings sentiment with continued upside revisions to US corporate profits and the expectation of ongoing economic growth, and the backdrop for risk assets remains conducive —albeit in a tight valuation environment (spreads sit in the bottom 25th and 10th percentile over the last 10 years).30
Senior loans’ floating rate structure may prove to be even more valuable should rate hikes impact the short end of the curve. Loans are up 40 basis points to start the year while all of the other 16 major bond segments we track are down on the year.31
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.
For high income strategies that may offer a yield above inflation expectations, consider the actively managed SPDR® Blackstone Senior Loan ETF [SRLN] that has roughly 0.2 years of duration,32 or the actively managed SPDR® Blackstone High Income ETF [HYBL] that allocates to multiple high income credit sectors, such as senior loans, high yield and collateralized loan obligations with a duration of approximately 1.5 years.33
3. Target non-traditional total return opportunities with convertibles
With return prospects low for traditional bonds, consider adding in a non-traditional source of potential return like convertible securities.
As a hybrid asset class, convertible securities combine the upside potential associated with equities alongside a coupon payment and bond floor. With generally higher yields than stocks and low correlations to fixed income sectors (22% to the Agg),34 convertibles could be a powerful tool for investors seeking growth, income and diversification.
For starters, convertibles have performed well during rising rate periods, relative to traditional fixed income sectors. Evidenced by the data below, for months in which the US 2-year yield increased (the rate most sensitive to Federal Reserve policy), convertibles have had stronger performance than the Agg, IG Corporates and US High Yield.
Average Monthly Performance When US 2-Year Rises
Convertibles are more equity sensitive than traditional bond sectors, including the equity biased high yield market, and their equity profile is different from broad-stock exposures to date, however, the stock level exposure has been a detractor of performance for convertibles. Yet, while the underlying stocks fell 10% in Q1, convertibles returned -6.3%.35 This means that converts participated in roughly 63% of the equity drawdown, positioning them as a risk-controlled growth equity position — even though the underlying equity exposure is more volatile than the broad market.
A convertible security’s delta measures the convertible bond’s sensitivity to the underlying stock, and a premium measures the difference between the price of the convertible and the parity. A low delta and high premium indicates a convertible security that is behaving more like a bond, than a stock. Currently, the delta (59.76) is below the historical median (65.49), and the premiums (35.45) are above the historical median (29.94).36
Given their more bond/credit like sensitivity, convertibles are now more of a yield solution, with their yield rising to above 3% from nearly 1% to start the year.37 As a result, convertibles now yield more than traditional stocks (1.36%) and can offer some income potential38 along with more potential total return upside given the bond-like starting point.
1 Bloomberg Finance L.P. as of April 6, 2022 based on Fed Funds Future Pricing. 2 Bloomberg Finance L.P. as of April 6, 2022 based on Fed Funds Future Pricing. 3 Bloomberg Finance L.P. as of April 6, 2022. 4 Bloomberg Finance L.P. as of April 6, 2022. 5 “Brainard Says Fed to Shrink Balance Sheet Rapidly as Soon as May,” Bloomberg April 5, 2022. 6 “Fed Officials Weigh Pruning Balance Sheet by $95 Billion a Month,” Bloomberg April 6, 2022. 7 Bloomberg Finance L.P. as of April 6, 2022 based on the difference between the US 2-year yield and the Fed Funds Target Rate from 1976-2022 using monthly intervals. 8 Bloomberg Finance L.P. as of April 6, 2022 based on the difference between the US 2-year yield and the Fed Funds Target Rate from 1976-2022 using monthly intervals. 9 Bloomberg Finance L.P. as of April 6, 2022 based on SPDR Americas Research calculations. 10 Bloomberg Finance L.P. as of April 6, 2022 based on SPDR Americas Research calculations. 11 Bloomberg Finance L.P. as of April 6, 2022 based on the yield on the US 10-year yield and the US 5-year breakeven rate. 12 Bloomberg Finance L.P. as of April 6, 2022. Stock volatility as measured by the CBOE VIX Index. Currency-implied volatility is measured by the J.P. Morgan Global FX Volatility Index. Rates-implied. volatility is measured by the MOVE Index. Oil-implied volatility is derived from oil future contracts. 13 Bloomberg Finance L.P. as of April 6, 2022 based on the CITI Macro Risk Index. 14 Bloomberg Finance L.P. as of April 6, 2022 based on Bloomberg US Aggregate Bond Index. 15 Bloomberg Finance L.P. based on the average option adjusted duration of the Bloomberg US Aggregate Index in 1994 versus today per calculations by SPDR Americas Research. 16 Bloomberg Finance L.P. as of April 6, 2022 based on the Bloomberg US Aggregate Bond Index. 17 Bloomberg Finance L.P. as of April 6, 2022 based on the Bloomberg US FRN < 5 Years Index. 18 Bloomberg Finance L.P. as of April 6, 2022 based on the Bloomberg US 1-5 year Government/Credit Float-Adjusted Bond Index. 19 Bloomberg Finance L.P. as of April 6, 2022 based on the Bloomberg US FRN < 5 Years Index. 20 Bloomberg Finance L.P. as of April 6, 2022 based on the Bloomberg US 1-5 year Government/Credit Float-Adjusted Bond Index. 21 Bloomberg Finance L.P. as of April 6, 2022 based on current portfolio holdings and the option adjusted duration (OAD) metric. 22 Bloomberg Finance L.P. as of April 6, 2022 based on average quarterly historical portfolio holdings and the option adjusted duration (OAD) metric since 2015, the strategy inception date compared to the Bloomberg US Aggregate Bond Index. 23 Bloomberg Finance L.P. as of April 6, 2022 based on quarterly yield changes on the Bloomberg US Aggregate Bond Index since 1976 to 2022. 24 Bloomberg Finance L.P. as of April 6, 2022 based on yield data for the Bloomberg US Aggregate Bond Index since 1976 to 2022. 25 Bloomberg Finance L.P. as of April 6, 2022 based on the Bloomberg US Aggregate Bond Index, the year-over-year CPI measure, and the US 5-year breakeven. Past performance is not a reliable indicator of future performance. 26 Based on the monthly returns of the Bloomberg EM Local Currency Government Diversified Index and the return on the MSCI EM Local Currency Index, per Bloomberg Finance L.P. data from 2012 to 2022 as of March 31, 2022. 27 Bloomberg Finance L.P. as of April 6, 2022. Currency-implied volatility is measured by the J.P. Morgan Global FX Volatility Index. 28 Bloomberg Finance L.P. as of April, 2022 based on S&P rating upgrades and downgrades for the U.S. Investment and High Yield market. 29 Moody’s Investor Service, February, 2022. 30 Bloomberg Finance L.P. as of April 6, 2022 based on the ICE BofAML US High Yield Index and the Bloomberg US Corporate Bond Index. 31 Based on the return of the S&P/LSTA Leveraged Loan Index as of April 6, 2022. 32 Based on the holdings as of April 6, 2022 per Bloomberg Finance L.P. calculations. 33 Based on the holdings as of April 6, 2022 per Bloomberg Finance L.P. 34 Based on monthly returns of the Bloomberg U.S. Convertibles Liquid Bond Index and the Bloomberg US Aggregate Bond Index since 2017 to 2022. 35 Based on the average return of the underlying equity exposure of the current holdings of the Bloomberg U.S. Convertibles Liquid Bond Index as of March 31, 2022 per Bloomberg Finance L.P. 36 Barclays as of March 31, 2022 based on the holdings of the Bloomberg U.S. Convertibles Liquid Bond Index. Past performance is not a reliable indicator of future performance. 37 Barclays as of March 31, 2022 based on the Bloomberg U.S. Convertibles Liquid Bond Index. 38 Bloomberg Finance L.P. as of March 31, 2022 for the Russell 3000 Index. 39 Morningstar as of April 6, 2022 based on the Morningstar Convertible Bond Category.
Bloomberg Aggregate Bond Index A benchmark that provides a measure of the performance of the US dollar-denominated investment-grade bond market. The “Agg” includes investment-grade government bonds, investment-grade corporate bonds, mortgage pass-through securities, commercial mortgage-backed securities and asset-backed securities that are publicly for sale in the US.
High Yield A company or bond that is rated “BB” or lower is known as junk-grade or high yield, in which case, the probability that the company will repay its issued debt is deemed to be speculative.
Investment-Grade Credit A fixed income security, such as a corporate or municipal bond, that has a relatively low risk of default. Bond-rating firms, such as Standard & Poor’s, use different lettered descriptions to identify a bond’s credit quality. In S&P’s system, investment-grade credits include those with “AAA” or “AA” ratings (high credit quality), as well as “A” and “BBB” (medium credit quality). Anything below this “BBB” rating is considered non-investment-grade.
Senior Loans Floating-rate debt issued by corporations and backed by collateral, such as real estate or other assets.
Treasuries The debt obligations of a national government. Also known as “government securities,” Treasuries are backed by the credit and taxing power of a country, and are thus regarded as having relatively little or no risk of default.
Volatility The tendency of a market index or security to jump around in price. Volatility is typically expressed as the annualized standard deviation of returns. In modern portfolio theory, securities with higher volatility are generally seen as riskier due to higher potential losses.
Yield The income produced by an investment, typically calculated as the interest received annually divided by the price of the investment. Yield comes from interest-bearing securities, such as bonds and dividend-paying stocks.
Important Risk Discussion
The views expressed in this material are the views of Matthew Bartolini and through the period ended March 31, 2022, and are subject to change based on market and other conditions. This document contains certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected.
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