CIO Lens Q4 2022: we need to talk about yields

At the beginning of 2022 summer, I asked the question “are we there yet?”, in relation to whether it was time to start thinking about taking on more investment risk. The answer then was no.

At that time, although market valuations had cheapened, we were still concerned that investors were underestimating inflationary risks, being premature in their expectation of a “Fed pivot” away from interest rate hikes, and had elevated expectations for corporate earnings.

Inflation over growth

So, what’s changed since then?  

It’s clear that central banks are willing to sacrifice growth at the altar of quelling inflation; investors are now moving from denial to acceptance of this.

The US 10-year nominal Treasury yield is 4% and the 10-year real yield (that is, adjusted for inflation) is above 1%. Significant rate increases from the major central banks are reflected in prices. So too is a recession, as seen in the “inverted” yield curve, which is when short-term bond yields are higher than long-term. 

As we said in Q3 2022, we are entering the phase of the cycle where investors' expectations for growth are disappointed. This is currently seen in deteriorating corporate earnings revisions. As liquidity tightens, we have also started to see the first signs of stress; most evidently at the moment in the UK government bond market, with potential repercussions for other assets as UK defined benefit pension plans look to rebuild collateral buffers.

Where do we go from here?

It is important to remember that this isn’t the first time we have seen bear markets driven by rising interest rates. History doesn't repeat, but it rhymes. The sources of fragility will vary from cycle to cycle, but as active investors we have the frameworks to price these challenges and consider relative valuations across asset classes.   

The improvement in valuations is most obvious in fixed income markets. We think it is now time to start talking about yield. 

For example, US investment-grade bonds – that is, those deemed by credit agencies to be the highest quality - have gone from a yield of 2.2% 12 months ago to a yield of 5.6% in late October 2022 when I wrote this. 

High yield (debt with a credit rating below investment grade) and hard currency (US dollar) emerging market debt offer yields above 9%. 

This shows that we are starting to be rewarded for taking risk in bonds as higher starting yields also act as an income cushion for investors against the impact of further price declines. 

Rising yields means falling prices, but with higher income a portfolio of bonds can withstand a larger increase in yields before total returns turn negative.

Taking into account the different interest rate sensitivity or “duration” of bonds, what this means today in the case of US investment grade is that yields could rise by 0.8% and this would lead to a price fall of 5.6%. However, this would be offset by the 5.6% yield, or income, on offer.

What are the caveats? To benefit from yields, you need to be a medium-term investor to withstand any near-term volatility - as we head into recession, credit spreads could widen further. 

The credit spread is the difference in yield between bonds of a similar maturity but with different credit quality. As spreads widen, this tends to mean yields rise/prices fall.

Nevertheless, if you are still with me after this technical passage, it is now possible to construct more positive scenarios for bonds as we head into 2023.

We are still cautious on equities as we need corporate earnings expectations to adjust down further. 

So, aside from capitulation on the corporate earnings front, what would be triggers for us to become more bullish? Signs of slowing in either commodity price inflation or wage growth would be encouraging, as they would allow central banks to back off from raising rates. For now, patience is still a virtue.

Team work in tough times

As the bad news keeps on coming, many people are struggling. At times like this, whether it’s in the community or in the workplace, people need support from their family, friends and colleagues. Investment teams are no different, and that’s why human behaviour and a supportive culture should be an inextricable part of any investment process.

It’s more important than ever to draw on this culture; to ensure everyone keeps a cool head and to ensure that team morale isn’t impacted by frustration about events that are out of our hands. We need to ensure that we continue to debate vigorously and scrutinise our positions, while also cultivating a supportive environment for our fund managers and analysts.

As investors, we are used to living with regret; there is always a better decision we could have taken. But the risk of regret is magnified when volatility increases.

At Schroders, we believe in each investment team being accountable for its performance and process. There are many ways to skin a cat, but there are some common attributes among the best team leaders. Typically, they are honest about their wrong turns, humble in their management of risk and open to the opinions of others, no matter how junior. This is what ultimately allows them to navigate difficult markets.  

Across the teams we also strive to create a supportive investment community, where insights, as well as the trials and tribulations of money management, are shared. 

I often say that I could show you all of our investment models, but it wouldn't tell you how to manage portfolios; it is our culture that sets us apart. It is our edge. 2022 more than most has certainly showed us the benefits of being part of our community of active investors. And we are highly motivated by the investment opportunities which are likely to arise in the next few months.