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:
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.
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
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
Owning high quality, uncorrelated assets can help defend portfolios against losses during periods of rate and equity volatility as you pursue return opportunities. Consider:
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.
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.
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
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.
For strategies that help manage duration risks in the pursuit of income, consider:
1 Bloomberg Finance, L.P., as of 5/12/2023 based on the ICE BofA MOVE Index and the trailing 90-day standard deviation of returns for the Bloomberg US Aggregate Bond Index.
2 BoFA US High Yield Strategy 4/30/2023.
3 “Fed Hikes Rates by Quarter Point, Powell Hints at Possible Pause,” Bloomberg, May 4, 2023.
4 “Fed’s Bullard says he has an open mind towards further rate hikes”, Reuters, May 5, 2023.
5 Bloomberg Finance, L.P., as of 05/10/2023.
6 Bloomberg Finance, L.P., as of 05/12/2023 based on the Bloomberg US Long Treasury Bond Index.
7 Bloomberg Finance, L.P., as of 05/12/2023 based on the S&P 500 Index.
8 Bloomberg Finance, L.P., as of 05/12/2023 based on the Bloomberg US Treasury Bond Index.
9 Bloomberg Finance, L.P., as of 05/12/2023 based on the Bloomberg US Treasury Bond Index.
10 Bloomberg Finance, L.P., as of 05/12/2023 based on the ICE BoFA US High Yield Index.
11 Bloomberg Finance, L.P., as of 05/12/2023 based on the ICE BoFA US High Yield Index.
12 Bloomberg Finance, L.P., as of 05/12/2023 based on the ICE BoFA US High Yield Index.
13 As of 05/12/2023 based on the BoFA Global Credit Research data.
14 As of 05/12/2023 based on the BoFA Global Credit Research data.
15 As of 05/12/2023 based on the BoFA Global Credit Research data.
16 Bloomberg Finance, L.P., as of 05/12/2023 based on S&P ratings actions for high yield issuers in North America.
17 As of 05/12/2023 based on the BoFA Global Credit Research data.
18 BoFA US High Yield Strategy 4/30/2023.
19 Bloomberg Finance, L.P., as of 05/12/2023.
20 FactSet, as of 04/28/2023.
21 Bloomberg Finance, L.P., as of 5/12/2023 based on the return and yield of the Bloomberg US Aggregate Bond Index from 1980-2023.
22 Bloomberg Finance, L.P., as of 5/12/2023 based on the return and yield of the Bloomberg US Aggregate Bond Index from 1980-2023.
23 Bloomberg Finance, L.P., based on the Bloomberg US Corporate 1-3 Year Index as of 5/12/2023.
24 Bloomberg Finance, L.P., based on 5-year standard deviation of returns for the Bloomberg US Corporate 1-3 Year Index versus the S&P 500 Index, the Bloomberg US Aggregate Bond Index, the Bloomberg US Corporate Bond Index as of 5/12/2023.
25 Based on weekly returns for the Bloomberg US Mortgage Backed Securities (MBS) Index and the S&P 500 Index over the last 10 years the correlation is 0.13 as of 05/12/2023 per Bloomberg Finance L.P. data.
26 Bloomberg Finance, L.P., as of 05/12/2023 based on the MBA US Refinancing Index.
27 Bloomberg Finance, L.P., as of 05/12/2023 for Bloomberg US Mortgage Backed Securities (MBS) Index.
28 Bloomberg Finance, L.P., as of 05/12/2023 for Bloomberg US Mortgage Backed Securities (MBS) Index.
29 Bloomberg Finance, L.P., as of 5/12/2023 based on data from 05/2003 to 05/2023.
Basis Point (bps)
A unit of measure for interest rates, investment performance, pricing of investment services and other percentages in finance. One basis point is equal to one-hundredth of 1 percent, or 0.01%.
The potential for an investment loss based on the borrower’s inability to repay a loan or meet other obligations. Credit risk is typically measured by credit ratings maintained by credit ratings agencies such as S&P, Moody’s and Fitch.
A commonly used measure, expressed in years, which measures the sensitivity of the price of a bond or a fixed-income portfolio to changes in interest rates or interest-rate expectations. The greater the duration, the greater the sensitivity to interest rates changes, and vice versa. Specifically, the specific duration figure indicates, on a percentage basis, by how much a portfolio of bonds will rise or fall when interest rates shift by 1 percentage point.
Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA)
An approximate measure of a corporation’s operating cash flow that is used to analyze and compare profitability between companies and industries because it eliminates the effects of financing and accounting decisions.
Federal Funds Rate, or Federal Funds Target Rate
The overnight interest rate charged by depositary institutions on funds held at the Federal Reserve. The fed funds rate is set by the Fed’s policy-making body, the Federal Open Market Committee, or FOMC.
Global Financial Crisis
The economic crisis that occurred from 2007-2009 that is generally considered biggest economic challenge since the Great Depression of the 1930s. The GFC was triggered largely by the sub-prime mortgage crisis that led to the collapse of systemically vital US investment banks such as Lehman Brothers. The crisis began with the collapse of two Bear Stearns hedge funds in June 2007, and the stabilization period began in late 2008 and continued until the end of 2009.
An overall increase in the price of an economy’s goods and services during a given period, translating to a loss in purchasing power per unit of currency. Inflation generally occurs when growth of the money supply outpaces growth of the economy. Central banks attempt to limit inflation, and avoid deflation, in order to keep the economy running smoothly.
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.
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.
Yield to Worst
The lowest potential yield that investors can expect when investing in a callable bond without the issuer defaulting.
S&P 500 Index
The S&P 500® is widely regarded as the best single gauge of large-cap U.S. equities and serves as the foundation for a wide range of investment products. The index includes 500 leading companies and captures approximately 80% coverage of available market capitalization.
Bloomberg US Aggregate Index
A broad-based flagship benchmark that measures the investment grade, US dollar-
denominated, fixed-rate taxable bond market. The index includes Treasuries, government-related and corporate securities.
ICE BofA MOVE Index
This is a yield curve weighted index of the normalized implied volatility on 1-month Treasury options.
This communication is not intended to be an investment recommendation or investment advice and should not be relied upon as such.
The views expressed in this material are the views of Michael Arone Matthew Bartolini, and Anqi Dong through the period ended May 19, 2023 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.
All information is from SSGA unless otherwise noted and has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. There is no representation or warranty as to the current accuracy, reliability or completeness of, nor liability for, decisions based on such information, and it should not be relied on as such.
Past performance is not a reliable indicator of future performance.
The whole or any part of this work may not be reproduced, copied or transmitted or any of its contents disclosed to third parties without SSGA's express written consent.
Investing involves risk including the risk of loss of principal.
Diversification does not ensure a profit or guarantee against loss.
Frequent trading of ETFs could significantly increase commissions and other costs such that they may offset any savings from low fees or costs.
While the shares of ETFs are tradable on secondary markets, they may not readily trade in all market conditions and may trade at significant discounts in periods of market stress.
Passively managed funds invest by sampling the index, holding a range of securities that, in the aggregate, approximates the full Index in terms of key risk factors and other characteristics. This may cause the fund to experience tracking errors relative to performance of the index.
Actively managed funds do not seek to replicate the performance of a specified index. An actively managed fund may underperform its benchmarks. An investment in the fund is not appropriate for all investors and is not intended to be a complete investment program. Investing in the fund involves risks, including the risk that investors may receive little or no return on the investment or that investors may lose part or even all of the investment.
TOTL and HYBL are actively managed. The sub-adviser’s judgments about the attractiveness, relative value, or potential appreciation of a particular sector, security, commodity or investment strategy may prove to be incorrect, and may cause the fund to incur losses. There can be no assurance that the sub-adviser’s investment techniques and decisions will produce the desired results.
Bonds generally present less short-term risk and volatility than stocks but contain interest rate risk (as interest rates rise, bond prices usually fall); issuer default risk; issuer credit risk; liquidity risk; and inflation risk. These effects are usually pronounced for longer term securities. Any fixed income security sold or redeemed prior to maturity may be subject to a substantial gain or loss.
Investing in high yield fixed income securities, otherwise known as "junk bonds", is considered speculative and involves greater risk of loss of principal and interest than investing in investment grade fixed income securities. These Lower-quality debt securities involve greater risk of default or price changes due to potential changes in the credit quality of the issuer.
Investments in asset backed and mortgage-backed securities are subject to prepayment risk which can limit the potential for gain during a declining interest rate environment and increases the potential for loss in a rising interest rate environment.
The trademarks and service marks referenced herein are the property of their respective owners. Third party data providers make no warranties or representations of any kind relating to the accuracy, completeness or timeliness of the data and have no liability for damages of any kind relating to the use of such data.
Distributor: State Street Global Advisors Funds Distributors, LLC is the distributor for some registered products on behalf of the advisor. SSGA Funds Management has retained DoubleLine Capital LP and Blackstone Liquid Credit Strategies LLC as the sub-advisors. State Street Global Advisors Funds Distributors, LLC is not affiliated with DoubleLine Capital LP or Blackstone Liquid Credit Strategies LLC.