Turning positive? Three reasons to look at fixed income again

To say 2022 has been a difficult year for fixed income investors is a gross understatement. With central banks across developed economies responding to inflation reaching 40-year highs, bonds have repriced significantly, causing the largest losses across the fixed income spectrum in many years.

In the US, the yield curve has flattened substantially since the beginning of the year; almost the whole curve now exceeds 4% (Chart 1).

Source: Bloomberg, as of 10 November 2022

In the UK, intermediate (7-10 year) gilts have been a significant underperformer, selling off by more than 260 bps to get to a current yield level of 3.54%, while returning -16.9%. For those investors who either track a benchmark or had a low flexibility tolerance and had to own negatively yielding bonds in markets such as Germany, they also felt a lot of pain. German intermediate government bond yields rose 235 bps to +2.06%, resulting in a negative return exceeding 16%.

The flip side to these market moves is that not only are the yields on offer in most fixed income sectors considerably higher today than in the past , but the amount of negatively yielding debt has all but evaporated (Chart 2). From a high of USD18 trillion at the end of 2020, now there is less than USD 2 trillion of negative yielding debt outstanding.

Chart 2: Universe of negative yielding debt shrinks over 2022

Source: Bloomberg Global Aggregate Negative Yielding Debt Market Value (USD) Index, as of 11 November 2022

Source:Bloomberg, data period from 2 February 2002 to 31 October 2022. Returns are gross of fees.

Despite the large role yield plays in total return, it only contributes a minor proportion towards total return volatility. Looking at Chart 4 – which simplistically displays yield and price as a proportion of total return volatility – we can see that while yield has contributed the most to total return over the past two decades, it has done so while contributing a lower percentage to the overall volatility.

Chart 4: Fixed income sub asset class volatility broken down by price and yield over the past 20 years

Source:Bloomberg, standard deviation data period from 2 February 2002 to 31 October 2022.

2: Higher break-even rates (from higher yields) act as ‘shock absorbers’

Break-evens in this context simply refer to the magnitude of rate increases needed to wipe out the head-start provided by yield income from a total return perspective. In general, the higher the level of yield, the larger the magnitude of rate increases required to generate a negative total return (i.e., wipe out positive contribution from income). In Table 1, we show break-evens for major fixed income asset classes and how much they have changed since the beginning of the year.

Looking at the Global Aggregate Corporates Index break evens have risen from needing 25bps of yields rising to 92bps before negative total returns set in. The short duration sectors are really shining: this is because curves have flattened, and short duration assets have much less interest rate sensitivity. At the end of 2021 the Global Aggregate 1–3 Year Index required just a 38 bps rise in bond yields to generate a negative return. More recently, this same benchmark now requires nearly 190 bps of yield increases to erase its higher yield advantage.

3: Investors no longer need to reach for yield by taking unnecessary credit risk

In a regime of ultra-low government bond yields and steep yield curves, investors in developed markets bonds were faced with a rather difficult trade-off: generate higher yields by going out further on the maturity curve and taking on more interest rate risk, or take on more credit risk by moving down the credit quality spectrum.

As Chart 5 shows, at the end of last year, only a quarter of the market offered yields of more than 2% (in USD). Today, this universe has more than tripled to 83%. We would argue that this development allows for a much better starting point for investors to achieve their investment goals, with an ability to build a much more diversified portfolio in terms of both issuers and sectors.

Chart 5: The growth in the proportion of the fixed income market yielding 2% or more

Source: Bloomberg, as of end October 2022. The Global fixed income universe is proxied by the Bloomberg Multiverse Index. The Bloomberg Multiverse index provides a broad-based measure of the global fixed income bond market: The index is the union of the Global Aggregate Index and the Global High Yield Index as it represents investment grade and high yield bonds in local currency terms.

Investors now have much greater flexibility to achieve their yield targets, but clearly, while there are benefits to having higher yields today, we should keep in mind that, with the Federal Reserve and other central banks focused on stamping out persistently high inflation, markets are likely to remain volatile over the short-to-medium term. However, for long-term investors, bonds are arguably better placed today to handle any further price declines than in the past.