Bonds Are Back: Take 2

There will come a time for investors to move out along the curve, likely once the interest rate hiking cycle comes toward an end. However, we are not there yet; being too early can be costly to investors’ returns. In the meantime, investors can earn attractive returns in the front-end.

The year of the front-end bond

So far, 2023 has been the year of the Treasury Bill, despite all the calls early in the year, for it to be the year of the bond.

Elevated front-end Treasury yields made investors reluctant to move further out along the curve and invest in lower yields. The combination of an inverted Treasury yield curve and limited upside from investment grade spreads (aside from a short period of widening in March’s banking crisis) made investors generally indifferent about increasing their allocations to investment grade bonds.

Now, heading into the final part of the year, we revisit our call of “Bonds are Back” and look at what we got right, what we got wrong and, more importantly, where we go from here.

Our call in early 2023 to allocate to high grade bonds remains intact. Our call then and now is premised on the attraction of owning investment grade bonds, especially those with nearer maturities, where yields are over 6%—a level not seen since late 2009. In fact, once yields of the Bloomberg US Corporate Bond Index  reach 5.75% historically the index delivered positive total returns in the following three, six and 12 months since 2000, excluding the Global Financial Crisis period.¹

Back in February we thought investors would be better served by owning the front-end part of the high grade universe on account of the elevated front end Treasury yields. This played out. Total returns have been higher in the front-end part of the High Grade market; the Bloomberg US Corporate Bond 1-3 Year Index is up 2.2% year to date compared to longer duration Bloomberg US Corporate Index which is down 1.4% year to date.

We also believe high-grade front-end bonds still offer attractive risk-return attributes as high current yields, supported by elevated Treasury rates, provide investors with a degree of downside protection from spread widening. In effect, today’s high yields provide high grade investors with some insurance against negative spread widening outcomes.

One way to show the attractiveness of the front end is to look at how much would credit spreads would need to widen before total annual returns fall to zero. Using this screen, the attractiveness of owning front end bonds is made obvious especially when compared to the less attractive risk reward opportunities offered by longer dated bonds.

Looking at the Bloomberg US Corporate 1-3 Year Bond Index, credit spreads would need to widen by approximately 348 basis points before annual total returns turn negative. In other words, at the time of this writing, credit spreads would need to move from 91 basis points to 439 basis  points, pushing yields from 6..20% to 9.88%, before the income received from holding the index constituents was offset by resulting lower prices (bond prices and yields move in opposite directions). We don’t expect credit spreads to reach 439 basis points, and even if they did we believe it is unlikely they would stay there. For this to occur, it seems that a significant or severe negative event would have to occur in the economy that would most likely prompt the Federal Reserve to reduce rates. This in turn would cause interest rates and the yield curve to shift downward, which would offset price declines experienced by high grade bonds.

Now compare this to owning bonds further out the curve and the risk reward is less compelling. For example, owning the broad Bloomberg US Corporate Index which has a duration of over 6 years, credit spreads would need to widen by 95 basis points from 124 basis points to 218 basis points, which is the 90% percentile since 2002.

Figure 1:  Spreads would have to widen by 92 basis points to result in losses to US corporate credit (As of October 5, 2023)

Source: Bloomberg, MacKay Shields LLC

What stumped us in 2023

What has stumped us so far this year has been the resiliency of the US economy and the strength of the US consumer. A combination of strong fiscal stimulus, the benefit to corporations and home mortgage borrowers of locked-in low interest rates and consumers’ excess savings lessened the efficacy of monetary policy.

Almost 80% of corporate debt is being financed at pre-tightened interest rates (according to FHN Financial, September 8, 2023) and the duration of corporate debt has doubled over the last 25 years. All this means that the economy’s sensitivity to higher interest rates may well be lessened, at least in the short run.

Figure 2: Duration of corporate debt has doubled over last 25 years

Source: Bloomberg

A similar story is playing out on the consumer side. Almost two-thirds of all US residential mortgages have a fixed rate below 4%, well below the current rate of over 7%.

Figure 3: Almost two-thirds of mortgages have rates below 4% - Share of outstanding mortgages by interest rate at origination in first quarter 2023 (%)

Source: National Mortgage Database

We were also surprised by the return profile of investment grade. January was a particularly good month for total returns, with a gain of 4% in the Bloomberg US Corporate Bond Index . Since then, however, performance has waned to just 1.48% (See chart below).

Our two surprises are in fact related. High-grade total returns declined as we went through 2023 as government bond yields rose due to a robust economy. Higher government yields caused the price return component of the total return to decline. In contrast, the coupon and excess returns (returns excluding the impact of interest rates) have been generally stable to improving so far this year.

Figure 4:  Total return of the Bloomberg Corporate Index  in 2023: Fading after a strong start

Source: Bloomberg as of September 30, 2023

Where do we go from here?

We believe we are approaching the final stages of the tightening cycle in the context of a quiet macroeconomic backdrop. The banking crisis of March is behind us, and risk sentiment is generally sanguine. Over the last month, the US Bloomberg US Corporate Bond Index   has traded in a 6 basis point range—its tightest since November 2021—and credit spread volatility is low.

We see monetary policy, although less effective now, as having a cooling impact on the economy. Monetary policy works with a one-two punch. The immediate impact, or first punch, of a 525 basis point hike in the Federal Funds rate has been to slow the housing market and increase refinancing costs.

The second punch, the long and variable lag impact of monetary policy, is expected to dampen economic activity as we go through 2024.

Looking forward, we believe the impact of higher interest rates, now around 525 basis points above their levels at the start of 2022, will eventually impact the economy. The share of corporate debt maturing and repricing in the next year or so ending 2024 is relatively low at 9% compared with 26% in 2007 (according to Goldman Sachs). However,  the pace accelerates in 2025 through to 2026.

Figure 5: Debt maturity wall set to pick up in 2024

Source: Bloomberg as of September 21, 2023

A second impact will be felt from higher yields. For high grade bonds there is around 220 basis points differential between the coupon and the current yield on the average corporate bond. All of this means that issuers will face higher funding costs, as most issuers likely do not fully hedge their interest expense.

Time to consider adding duration in 2024

The current Federal Reserve tightening cycle is the seventh in the last four decades and the increase in rates (525 basis points) is the greatest experienced in any of these cycles. The average rate tightening cycle has lasted 21 months with an increase of around 300 basis points. The current tightening cycle is in its seventeenth month.

Today’s Federal Funds rate is substantially higher than the peak rates that occurred in the 2015-2018 period (peak rate of 2.375%) while closer to the 2004-2006 period (peak rate of 5.25%). However, in four of the other rate hiking periods, rates were higher and went through 6%.

Figure 6:  Nominal Federal Funds Target Rate Increases during FOMC Tightening Episodes since 1983

Source: Haver Analytics and author's calculations

Now is an appropriate time for investors to consider how they will position their portfolios as we come closer to the end of the Federal Reserve’s interest rate hiking cycle and as the Federal Reserve gets closer its next phase of interest rate policy, including possibly starting to cut interest rates at some point in 2024.

With front-end high grade yields over  6%, investors may be reluctant to move further out along the credit curve as yields decline, reflecting the inverted Treasury curve and unexciting credit spread curves.

To guide investors in assessing the risk-return opportunity of moving closer to the duration of the Bloomberg US Corporate Bond Index (just under 7 years), we look at how various asset classes have performed in an interest rate cutting cycle.

We look at the past six interest rate hiking periods and examine how different asset classes performed starting from the last hike in each period. We then average the overall performance to arrive at measure of performance.

We find that investors were well served by allocating more to high grade and high yield than simply owning cash. Equities are the biggest performer.

Figure 7:  Cumulative returns since the last Federal Reserve interest rate hike

Source: Bloomberg

We recognize we are not clairvoyant, and certainly this has been a year where the Federal Reserve surprised us, most recently when it signaled in mid-September that it might enact fewer interest rate cuts in 2024 and keep higher rates through 2025 and 2026. Ultimately, the path of interest rates all comes down to the trajectory of inflation and the pace of economic activity.

We recognize that, between 2022 and 2023, we were too early  to increase our allocation to high grade, so below we look at cumulative 3-year returns for periods starting 6 months before the last Fed hike.

From this, we can try to measure the potential cost of being early in adding to high grade. For example, a 12-month allocation made 6 months before the final rate hike would have returned 11%, compared with 16% if the allocation had coincided perfectly with the final rate hike. Roughly the same 5% give-up applies over 18, 24 and 36-month horizons.

Figure 8:  Cost of Being Early: Cumulative Returns Starting 6 Months Before the Last Federal Reserve Interest Rate Hike

Source: Bloomberg

Goldilocks solution: getting paid to wait for the Fed

Given the uncertainty about how long the Fed will keep interest rates elevated and when the rate cutting cycle begins, the Goldilocks solution is likely the best investment approach

In this scenario, credit investors can still find attractive opportunities. Yields for high-grade credit are at multi-year highs. In fact, we have to go back to 2001 to see an extended period when yields on bonds with maturities between 1 and 5 years are as high as they are now.

At the same time, corporate credit yield curves have flattened dramatically compared with history. This means investors are getting paid less to own credit spread duration. Figure 9 compares the yields of corporate bonds of different maturities. The ratio of yields on long versus intermediate, and intermediate versus short credit, are near historic lows.

Figure 9: Investors are not being paid to own spread duration

Source: Bloomberg

Investors are being paid to wait for the Fed in 2024

When we put this altogether, we believe investors are best served by waiting for the Federal Reserve to get closer to actually cutting rates. In the meantime, in our view investors should:

• Take advantage of historically high all-in yields at the front end;
• Recognize general unattractiveness of credit spreads and the limited opportunities to achieve excess returns; and
• Manage interest rate convexity, especially as credit spread convexity is less relevant in the current narrow spread environment while interest rate volatility risk remains high.

To achieve these portfolio characteristics, we have tilted our high grade portfolios to high-front-end carry, avoiding unnecessary spread duration exposure, and adding duration by owning longer dated higher quality corporates and longer-dated Treasuries to achieve appropriate duration exposure.

Figure 10: Elevated corporate yields across all tenors, but little reason to look beyond the front end, yield to worst (%)

Source: Bloomberg as of September 21, 2023

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This material contains the opinions of certain professionals at MacKay Shields but not necessarily those of MacKay Shields LLC. The opinions expressed herein are subject to change without notice. This material is distributed for informational purposes only. Forecasts, estimates, and opinions contained herein should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. Any forward-looking statements speak only as of the date they are made and MacKay Shields assumes no duty and does not undertake to update forward-looking statements. No part of this document may be reproduced in any form, or referred to in any other publication, without express written permission of MacKay Shields LLC. ^©2023, MacKay Shields LLC. All Rights Reserved. 

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Comparisons to a financial index are provided for illustrative purposes only. Comparisons to an index are subject to limitations because portfolio holdings, volatility and other portfolio characteristics may differ materially from the index. Unlike an index, portfolios are actively managed and may also include derivatives. There is no guarantee that any of the securities in an index are contained in any managed portfolio. The performance of an index may assume reinvestment of dividends and income, or follow other index-specific methodologies and criteria, but does not reflect the impact of fees, applicable taxes or trading costs which, unlike an index, may reduce the returns of a managed portfolio. Investors cannot invest in an index. Because of these differences, the performance of an index should not be relied upon as an accurate measure of comparison.

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The following indices may be referred to in this document:

ICE BOFA US CORPORATE INDEX

The ICE BofA  US Corporate Index tracks the performance of U.S. dollar denominated investment grade corporate debt publicly issued in the U.S. domestic market. You cannot invest directly in an index.

ICE BOFA US HIGH YIELD INDEX

The ICE Bank of America US High Yield Index is market capitalization weighted and is designed to measure the performance of U.S. dollar denominated below investment grade (commonly referred to as “junk”) corporate debt publicly issued in the U.S. domestic market.

ICE BOFA EURO CORPORATE INDEX

The ICE BofA Euro Corporate Index tracks the performance of Euro denominated below investment grade corporate debt publicly issued in the euro domestic or eurobond markets.

ICE BOFA EURO HIGH YIELD INDEX

The ICE BofA Euro High Yield Index tracks the performance of EUR denominated below investment grade corporate debt publicly issued in the euro domestic or eurobond markets.

ICE BOFA HIGH GRADE EMERGING MARKETS CORPORATE PLUS INDEX

The ICE BofA High Grade Emerging Markets Corporate Plus Index tracks the performance of U.S. dollar and euro denominated emerging markets non-sovereign debt publicly issued in the major domestic and eurobond markets rated AAA through BBB3, inclusive.

ICE BOFA HIGH YIELD EMERGING MARKETS CORPORATE PLUS INDEX

The ICE BofA High Yield Emerging Markets Corporate Plus Index is a subset of The ICE BofA Emerging Markets Corporate Plus Index including all securities rated BB1 or lower. ICE Bank of America  High Yield Master II Index tracks the performance of US dollar denominated below investment grade rated corporate debt publically issued in the US domestic market. To qualify for inclusion in the index, securities must have a below investment grade rating (based on an average of Moody's, S&P, and Fitch) and an investment grade rated country of risk (based on an average of Moody's, S&P, and Fitch foreign currency long term sovereign debt ratings).  Each security must have greater than 1 year of remaining maturity, a fixed coupon schedule, and a minimum amount outstanding of $100 million.

CREDIT SUISSE LEVERAGED LOAN INDEX

The Credit Suisse Leveraged Loan Index is an unmanaged index that represents tradable, senior-secured, U.S.-dollar-denominated non-investment-grade loans.

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