Bond prices have an inverse relationship to yield: When yield or interest rates increase or decrease, bond prices move in the other direction. By looking at the duration of an asset class, you can potentially estimate how much bond prices might move for every 1% shift in interest rates. Then you could add in the current yield to estimate the potential 12-month return. With the Federal Reserve now on pause, and the market likely anticipating rate cuts in 2024, here is a look at what the potential return might be for specific investment-grade fixed-income asset classes based off current duration and yield levels if the Fed decreased interest rates by 1%.
Source: Bloomberg as of 9/30/2023. The Bloomberg US Aggregate Bond Index (Agg) is composed of investment-grade U.S. government bonds, investment-grade corporate bonds, mortgage pass-through securities, and asset-backed securities, and is commonly used to track the performance of U.S. investment-grade bonds. U.S. Treasuries represent the Bloomberg US Treasury Index, which is made up of U.S. government bonds of various durations. Mortgage-Backed Securities represent the Bloomberg Mortgage-Backed Securities Index, a market value-weighted index composed of agency mortgage-backed pass-through securities. Commercial Mortgage-Backed Securities (CMBS) represent the CMBS company of the Bloomberg US Aggregate Bond Index. Investment-grade corporate bonds represent the Bloomberg US Credit Index, which measures the investment grade, US dollar-denominated, fixed-rate, taxable corporate and government related bond markets. Current yield is an investment’s annual income (interest or dividends) divided by the current price of the security. Duration is often used to measure a bond’s or fund’s sensitivity to interest rates. The longer a fund’s duration, the more sensitive it is to interest-rate risk.
Over the Long Run, Corporate Debt Has Outperformed Treasuries and Loans
Historically, the additional yield or spread offered by corporate debt has paid off for patient investors. Corporate debt has outperformed two of its more conservative fixed-income counterparts—U.S. Treasuries and mortgage-backed securities—over the past 31 rolling 10-year periods. Investment-grade corporate bonds outpaced those two asset classes 97% of the time, and high-yield outperformed them 90% of the time.
Source: Morningstar as of 7/1/1983 to 8/31/2023. U.S. Treasuries represent the Bloomberg US Treasury Index, which includes public obligations of the U.S. Treasury with a remaining maturity of one year or more. Mortgage-backed securities (MBS) represent the Bloomberg Mortgage-Backed Securities Index, which is a market value-weighted index composed of agency mortgage-backed pass-through securities of the Government National Mortgage Association (Ginnie Mae), the Federal National Mortgage Association (Fannie Mae), and the Federal Home Loan Mortgage Corporation (Freddie Mac). Investment grade is represented by Bloomberg US Corporate Index, which covers performance for United States corporate bonds. High-yield bonds represent the Bloomberg US Corporate High Yield Index, which measures the USD-denominated, high-yield, fixed-rate corporate bond market High-yield/high-risk bonds (“junk bonds”) and floating-rate loans (usually rated below investment grade) have greater risk of default than higher-rated securities/higher-quality bonds that may have a lower yield.
Why Now May Be the Time for Tax-Loss Harvesting
Since most fixed-income funds distribute the majority of their return in the form of monthly distributions, their price return is usually well below the total return. For example, the Bloomberg US Aggregate Bond Index has generated a price return of -2.67% over the trailing 12 months and -11.74% over the past five years. On the other hand, the total return for the index (adding distributions and capital gains) was 0.64% for the trailing 12 months and 0.51% for the past five years. Knowing this, investors may want to take advantage of the current environment and consider tax-loss harvesting their fixed-income losses from what have historically been considered conservative investment options.
Source: Morningstar as of 9/30/2023. The Bloomberg Aggregate Bond Index broadly tracks the performance of the U.S. investment-grade bond market. Price return typically captures the capital gain or loss without coupons or dividends. By comparison, total return captures both the capital gains and the income generated from coupons and dividends. Tax-loss harvesting is the timely selling of securities at a loss to offset the amount of capital gains tax owed from selling profitable assets.
After a Hiking Cycle, Longer Duration Has Historically Outperformed Shorter Duration
Historically, intermediate core plus bond funds have significantly outperformed money market and ultra short bond funds in the 12 months following a Federal Reserve hiking cycle, as longer duration bond investors have benefited from higher yields and more attractive relative value. While investors have added $614.1 billion to money market funds so far in 2023, there may be a better investment opportunity with longer duration assets should the Federal Reserve decide to take a pause in the current rate hiking cycle.
Source: Morningstar as of 8/31/23. Performance shows the average for Morningstar categories referenced (Money Market Funds, Ultra Short Bond Funds, and Intermediate Core Plus Bond Funds).
How Did Intermediate IG Bonds Perform After the Fed's Last Pause in 2018?
In the 12 months following the Federal Reserve’s last rate hike in December 2018, intermediate investment-grade corporate bonds outperformed the Bloomberg US Aggregate Bond Index by 1.42%. In addition to the higher returns, intermediate investment-grade corporate bonds also generated during this period 28% less volatility than the Bloomberg US Aggregate Bond Index; 57% less max drawdown than the Bloomberg US Aggregate Bond Index; and higher returns in the best and worst quarter than the Bloomberg US Aggregate Bond Index.
Source: Morningstar Direct as of 10/11/2023. The Bloomberg US Aggregate Bond Index is composed of investment-grade U.S. government bonds, investment-grade corporate bonds, mortgage pass-through securities, and asset-backed securities, and is commonly used to track the performance of U.S. investment-grade bonds. Intermediate investment-grade corporate bonds represent the Bloomberg US Intermediate Corporate Bond Index, which measures the investment-grade, fixed-rate, taxable corporate bond market and includes publicly issued securities that have between 1 and up to, but not including, 10 years to maturity. Volatility is most traditionally measured using the standard deviation. Larger standard deviations point to higher dispersions of returns as well as greater investment risk. Maximum drawdown is a metric that tracks the most significant potential percentage decline in the value of a portfolio over a given period. Federal funds rate refers to the target interest rate range set by the Federal Reserve. Investment grade is a rating that signifies a municipal or corporate bond presents a relatively low risk of default.
Why Duration After a Rate-Hiking Cycle Ends?
Historically, when a Federal Reserve rate-hiking cycle has ended, longer duration spread sectors have materially outperformed more traditional fixed-income and shorter-duration spread sectors in the following 12 months.
Source: Bloomberg and Morningstar. The Bloomberg US Aggregate Bond Index, or the Agg, is a broad base, market capitalization-weighted bond market index representing intermediate term investment-grade bonds traded in the United States. Short-term investment-grade corporate bonds represent the Bloomberg US 1-3 Credit Index. This index includes all medium and larger issues of U.S. government, investment-grade corporate, and investment-grade international dollar-denominated bonds that have maturities of between 1 and 3 years and are publicly issued. Long-term investment-grade corporate bonds represent the Bloomberg US Long Credit Index. This index measures the performance of investment grade, US dollar-denominated, fixed-rate, taxable corporate and government-related debt with at least ten years to maturity. Short-term high-yield bonds represent the Bloomberg 1-3 Year US Corporate High Yield Index. This index is an unmanaged, U.S. dollar–denominated, nonconvertible, non-investment-grade debt index. The index consists of domestic and corporate bonds rated Ba and below with a minimum outstanding amount of $150 million. Long-term high-yield bonds are represented by the Bloomberg US Long Corporate High Yield Index. This index covers performance for U.S. high-yield corporate bonds.
What Happened After Fed Last Paused Rate Hikes?
The Federal Reserve has predicted it will raise interest rates once more in 2023. But current market expectations are for a rate pause for the rest of the year and rate cuts to begin in 2024.
Source: Bloomberg as of 7/31/2023. Bank loans represented by Credit Suisse Leveraged Loan Index, which is designed to mirror the investable universe of the U.S. dollar-denominated leveraged loan market. High yield is represented by Bloomberg US Corporate High Yield Index, which measures the USD-denominated, high-yield, fixed-rate corporate bond market. Investment grade is represented by Bloomberg US Corporate Index, covers performance for United States corporate bonds. Aggregate is represented by the Bloomberg Aggregate Bond Index broadly tracks the performance of the U.S. investment-grade bond market.
Is the Time Right for Corporate Credit?
Historically, when investment-grade corporate bonds, high-yield bonds and bank loans have reached the same price and yield levels as today’s, they’ve generated a 12-month return well above each asset class’s 20-year annualized return.
Source: Bloomberg and Credit Suisse as of 5/31/23
Yield, Volatility and Bank Loans
Historically, if investors wanted higher levels of yield, they would have to take on higher levels of volatility. But over the past three years, bank loans have had lower levels of volatility than most investment-grade areas of the fixed-income market with higher levels of yield. Bank loans currently offer investors more than two times the yield of the Bloomberg US Aggregate Bond Index, while having delivered 32% less volatility over the past three years.
Source: Bloomberg and Credit Suisse as of 4/28/23. Monthly yields and volatility from 4/28/2020 to 4/28/2023. Investment-grade bonds are represented by the Bloomberg US Aggregate Bond Index. U.S. Treasuries represent the Bloomberg US Treasury Index, which includes public obligations of the U.S. Treasury with a remaining maturity of one year or more. Investment grade corporate bonds are represented by Bloomberg US Corporate Index, which covers performance for U.S. corporate bonds. High-yield bonds are represented by the Bloomberg US Corporate High Yield Index, which measures the USD denominated, high-yield, fixed-rate corporate bond market. Bank loans represented by the Credit Suisse Leveraged Loan Index, which is designed to mirror the investable universe of the U.S. dollar-denominated leveraged loan market. EM Local Debt is represented by the Bloomberg EM Local Currency Government Index, a country-constrained index designed to provide a broad measure of the performance of liquid local currency emerging markets debt.
Yields Across Corporate Credit Have Been Rising
Yields across corporate credit are currently far higher than at the end of 2021. In this environment, the additional credit risk may be worth the additional yield for investors.
Source: Bloomberg as of 7/31/2023. Investment-grade corporate bonds are represented by the Bloomberg US Credit Index, which measures the performance of U.S. investment-trade taxable corporate, fixed-rate, and government-related fixed-income securities. Short-term investment-grade investment bonds are represented by the Bloomberg 1-3 Year US Credit Index, which includes securities with a maturity of 1-3 years in the Bloomberg US Credit Index. Single A corporate bonds are represented by securities with a single A credit rating in the Bloomberg U.S. Credit Index. BBB corporate bonds are are represented by securities with a BBB credit rating in the Bloomberg U.S. Credit Index. High-yield bonds are represented by the Bloomberg US Corporate High Yield Index, which measures the USD denominated, high-yield, fixed-rate corporate bond market. Bank loans represented by the Credit Suisse Leveraged Loan Index, which is designed to mirror the investable universe of the U.S. dollar-denominated leveraged loan market. Yield to worst is the lowest potential yield that can be received on a bond without the issuer defaulting.
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