Boston - During the last decade, many investors moved away from traditional high-quality fixed income (core/core plus) U.S. bond strategies as ultra-low yields and compressed spreads limited income and total return opportunities. In the wake of an inflation and policy shock that led to an extremely volatile year, market dynamics have shifted.
As a result, we believe higher-quality, longer-duration, diversified fixed income portfolios are well-positioned to generate attractive total returns for three reasons:
- Starting yields are more attractive than at any time in recent memory.
- We have seen over time that starting yields are strongly correlated to future returns.
- Perhaps the best news for fixed income investors, with the higher level of yields contributing an increased percentage to total return potential, the pressure to precisely time the market entry is lessened.
Starting yields are at post-financial crisis highs
Bond yields surged in 2022 amid the most aggressive (both magnitude and speed) Fed tightening since the 1980s. Investment-grade sectors experienced some of the largest increases, with the nominal yield to worst1 (YTW) on the Bloomberg U.S. Aggregate Index nearly tripling over the course of the year, touching its highest level since 2008. Now in early 2023, high-quality, longer-duration bonds are compensating investors much more than they have historically with regard to their level of risk versus non-investment-grade assets.
Starting yields have been a reliable indicator of future returns
High current yields bode well for core and core plus strategies, as they have historically served as a good proxy for future returns. For example, our research shows that, for high-quality fixed income portfolios, the long-term correlation between the starting yield of the Bloomberg U.S. Aggregate Index and the Index's subsequent five-year return is 0.94, as shown in Display 1. The correlation is the same or higher when looking at returns for subsequent six- through 10-year periods.
Correlations are also positive across time periods for individual sectors of the U.S. income market. That said, they are generally not as strong as correlations for the broad market index, highlighting the benefits of diversification and quality.
Of the various sectors we evaluated, the predictive power of yield was weakest for lower-quality high-yield bonds, reflecting their default risk. Because of the principal losses associated with defaults and variable liquidation outcomes, a high-yield only bond allocation with, for example, a 6% yield might ultimately realize a lower yield.
A diversified investment-grade portfolio typically has a much higher probability of earning its starting yield relative to a lower-quality fixed income portfolio, particularly one with much higher default risk. We believe this greater predictive power is especially important as we position client portfolios for an uncertain macroeconomic outlook with a high probability of a recession.
Adding duration may help mitigate risk in portfolios and enhance total returns
The Fed has signaled that it will continue to tighten and then maintain restrictive policy in the months ahead, putting additional pressure on the U.S. economy, which is already showing signs of slowing. As the economy weakens further, we believe Treasury yields — which are most sensitive to future growth and inflation dynamics rather than current monetary policy — will decline.
History also suggests that longer-term yields are poised to decline. The 10-year Treasury yield has rallied after the Fed's final rate increase of the cycle in each of the past five tightening cycles, as illustrated in Display 2. With the fed funds target at 4.5% to 4.75% and an FOMC-projected terminal rate of 5.1%, we expect to see the final hike of this cycle by mid-2023.
In the falling rate environment we envision, core and core plus strategies with intermediate-term durations have the potential to generate total returns that are substantially higher than current yields — yields likely to be at post-crisis highs. This type of environment is less beneficial for lower-quality, higher-leveraged income sectors due to their much lower sensitivity to interest rates (lower effective durations).
Higher starting yields make entry points less relevant
Numerous studies have highlighted the dramatically negative performance impact that a U.S. equity portfolio can experience by missing out on a handful of specific "stock market's best days." This has not been the case with an investment-grade bond portfolio. Compared to equities, future total returns are less sensitive to market entry points because of the return cushion provided by the income component — a cushion that is particularly sizeable today.
Nonetheless, market entry points do matter. Our investment process is rooted in research that focuses on estimating the economic trends and policy posture for the situation and the financial market outcomes based on the two. While we expect longer rates to trend lower in 2023 in an environment of macroeconomic uncertainty and heightened volatility, picking the bottoms or peaks has a much lower information ratio,2 in our opinion. As shown in Display 3, our analysis suggests that investors may be better off adding core and core plus exposure ahead of peak yields.
Bottom line: We believe investors should give serious thought to increasing core and core plus exposure given the strong return profile of higher-quality, longer-duration U.S. fixed income. The past year has witnessed a regime shift, and there is now less of a cost in yield advantage and a compelling case for total return advantage in doing so — even when market entry points may seem uncertain.
We also believe investors can enhance that return profile by allocating to strategies with the flexibility to capitalize on relative value opportunities identified through bottom-up fundamental research. We anticipate seeing many such opportunities, as the Fed-induced economic slowdown will likely create market volatility and meaningful valuation dispersion among sectors, industries and securities — unlike mid-2020 to 2022 when spreads generally moved in lockstep. The ability of actively managed core plus strategies to invest in non-investment-grade assets can further enhance returns.
1 Yield to worst is a measure which reflects the lowest potential yield earned on a bond without the issuer defaulting. The yield to worst is calculated by making worst-case scenario assumptions by calculating the returns that would be received if provisions, including prepayment, call or sinking fund, are used by the issuer.
2 Information ratio is a measurement of portfolio returns beyond the returns of a benchmark index, compared to the volatility of those returns.
The index performance is provided for illustrative purposes only and is not meant to depict the performance of a specific investment. Past performance is no guarantee of future results.
Bloomberg U.S. Aggregate Index is an unmanaged index of domestic investment-grade bonds, including corporate, government and mortgage-backed securities. "Bloomberg®" and the Bloomberg Index/Indices used are service marks of Bloomberg Finance L.P. and its affiliates, and have been licensed for use for certain purposes by Morgan Stanley Investment Management (MSIM). Bloomberg is not affiliated with MSIM, does not approve, endorse, review, or recommend any product, and. does not guarantee the timeliness, accurateness, or completeness of any data or information relating to any product.
