Bonds Are Back to Work in Asset Allocation

Investors are well aware of the turmoil that occurred in the bond markets in 2022. What is perhaps less known is that the repricing in the fixed-income market substantially increased yields, making public, fixed-income markets an attractive asset class again. Here, we take a closer look at the opportunity in credit sectors and ways to use the full spectrum of fixed income investments available to help build more resilient asset allocations.

After a long period of accommodative monetary policy, slow economic growth, low inflation, and very low rates, the era of ZIRP, or zero interest-rate policy, is near an end. Surging inflation prompted swift and large rate hikes by the U.S. Federal Reserve (Fed) and other major central banks. Rates-oriented, government bonds that previously traded at a negative yield repriced accordingly. By the end of 2022, the total dollar amount of global, negative-yielding debt was near zero, down from a peak of nearly $18 trillion in 2020, as shown in Figure 1.

Figure 1. Negative Yields Have Become a Thing of the Past

Total dollar amount of debt trading at a negative yield in the Bloomberg Global Aggregate Index

Source: Bloomberg. Data as of 12/31/2022. Past performance is not a reliable indicator or guarantee of future results. For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment. Indexes are unmanaged, do not reflect the deduction of fees and expenses, and are not available for direct investment.

Higher Yields May Be Here for a While

But why were investors willing to accept negative yields for so long? In an economic environment of low and somewhat predictable inflation and declining rates, stocks and those negative-yielding, rate-sensitive government bonds remained negatively correlated. The diversification benefits of allocating to bonds endured.

In an inflationary environment, however, the negative return correlation between stocks and rate-sensitive bonds shifts positive. And although we do think inflation will eventually decline, we believe that a return to low inflation will require more time. Imbalances in the labor market, a reversal of economic globalization, energy supply issues, and ESG (environment, social, and governance)-related costs are all structural forces that we think will contribute to upward price pressures for an extended period. And if inflation remains elevated, rates may stay higher for a while longer.

Getting to those higher yields, however, was a challenge for bond investors as nearly all fixed-income sectors were negatively impacted by the historic upward move in rates. Importantly, though, the damage to total returns was almost entirely caused by rising rates (shown in Figure 2) as opposed to negative credit events. Overall, credit has remained strong due to generally healthy corporate balance sheets and profit margins that have held up well to high inflation.

Figure 2. Negative Returns in 2022 Were Driven by Rising Rates

Monthly, rolling 12-month ICE BofA U.S. Corporate Index returns decomposed by spread return and rate return, December 31, 1998-January 31, 2023

Source: Bloomberg. Data as of 01/31/2023. Past performance is not a reliable indicator or guarantee of future results. For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment. Indexes are unmanaged, do not reflect the deduction of fees and expenses, and are not available for direct investment.

Higher yields across credit sectors may now be a potential benefit for income-seeking investors and may also provide a viable reason to reassess allocations. We show in Figure 3 just how much yields have risen since the end of 2021 across sectors within the long-term and short-term segments of the market. While long-term or full-maturity credit sectors (top of Figure 3) offer yields that have not been reached in over a decade, short-maturity credit sectors (bottom of Figure 3) offer the potential for very attractive yields, as well as limiting duration risk if rates rise further.

Figure 3. Higher Starting Yields Create an Opportunity

YTW (yield-to-worst) offered on fixed-income sectors as of December 31, 2021, and February 28, 2023

Source: Bloomberg and ICE Data Indices, LLC. Data as of 02/28/2023. 10-year U.S. Treasury=Bloomberg 10-year Treasury Index. U.S. Aggregate=Bloomberg U.S. Aggregate Bond Index. Agency MBS (mortgage-backed security) =Bloomberg U.S. MBS Index. AAA ABS (asset-backed security) =Bloomberg ABS AAA Only Index. IG (investment grade) Corporate=Bloomberg U.S. Corporate Index. CMBS (commercial mortgage-backed security) =Bloomberg CMBS Index. High Yield Bond=Bloomberg U.S. Corporate High Yield Index. 2-Year U.S. Treasury=Bloomberg 2-Year Treasury Index. 1-3 year IG Corporate=Bloomberg U.S. Corporate 1-3 Year Index. 1-3 Year Corporate BBB=Bloomberg U.S. Corporate 1-3 Year BBB Index. 0-3 year AAA CMBS=ICE BofA 0-3 Year AAA U.S. Fixed Rate CMBS Index. 0-3 year ABS=ICE BofA 0-3 year AAA ABS Index. 1-3 year High Yield BB-B=ICE BofA 1-3 Year High Yield Index. Past performance is not a reliable indicator or guarantee of future results. For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment. Indexes are unmanaged, do not reflect the deduction of fees and expenses, and are not available for direct investment.

Thinking Long Term

With the era of low rates and low inflation likely at an end, and with the possibility for an extended period of inflation uncertainty, we believe fixed income may offer an improved, long-term opportunity. Other institutional investors and consultants who work with the institutional investment community have also been adjusting their long-term CMAs to align with the prospect of attractive yields in the public fixed-income markets. CMAs provide insight that may help guide asset allocation strategies. Figure 4 shows three sets of 10-year return expectations within CMAs developed by consultants for certain fixed-income segments. Each set has raised the long-term expected return for both the high yield and core bond sectors.

Figure 4. Expectations for Long-Term Fixed-Income Returns Have Been Trending Upward

10-year return expectations within fixed-income sectors as of the indicated dates

Source: Consultant reports. Data as of 12/31/2022 and 09/30/2022. *Core Bond includes the U.S. aggregate bond and investment-grade corporate bond categories. The data are part of CMAs developed by consultants and represent long-term, return expectations as of the dates shown. A complete, long-term CMA may also include expected volatility, or standard deviation of returns, as well as the expected return correlation, along with other projections. N/A=not applicable as the asset class was not represented in the report. Past performance is not a reliable indicator or guarantee of future results. For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment. Indexes are unmanaged, do not reflect the deduction of fees and expenses, and are not available for direct investment.

Reducing Complexity

Over the past decade or more, portfolio allocations to the public, fixed-income markets adjusted lower and were replaced by various asset classes that were projected to provide a potentially higher expected return to contribute to an overall long-term return target. Increasing the number of return-seeking asset classes represented in an asset allocation strategy implies increased complexity in terms of monitoring and reporting and may affect the overall level of liquidity and fees associated with the portfolio. We think public, fixed-income markets may now be a larger part of portfolio allocations, given the return of income in fixed income.

Figure 5 shows yields on investment-grade corporate bonds and short-duration, high-quality high yield bonds compared to the earnings yield on the S&P 500® Index. Stocks are generally a significant portion of return-seeking assets within investment allocations. Yet, the yield-to-worst (YTW) on investment-grade corporates and short-term high yield bonds are comparable or better. Investors may want to consider credit segments’ attractive yields as part of a potentially more simplified allocation approach.

Figure 5. Attractive Yields Rival Earnings Yield on Stocks

ICE BofA 1-3 Year U.S. High Yield BB-B Index YTW, ICE BofA U.S. Corporate Bond Index YTW, and the S&P 500 Earnings Yield, December 31, 1996, to February 28, 2023

Source: Bloomberg and ICE Data Indices, LLC. Data as of 01/31/2023. Past performance is not a reliable indicator or guarantee of future results. For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

Summing Up

Over time, as fixed-income yields declined, investors reached into other asset classes outside of the public markets to augment the prospect for higher returns. This has potentially increased complexity and fees. Long-term, public fixed-income return projections within CMAs have been trending higher as yields have increased due to higher rates, and credit has remained strong.

Although inflation may subside with the Fed intent on keeping it in check, short-term credit offers very attractive yields while limiting duration risk if rates move higher. Higher yields also create an attractive entry point for core bonds, given the uncertainty in rates and Inflation. We think investors may want to consider a flexible approach balancing short-duration credit within a core bond portfolio, and we believe the public fixed-income markets may offer an additional opportunity to reduce complexity while seeking to achieve return targets and limit volatility.