Is there a bond opportunity hiding in plain sight?

Bond markets have taken a hit over recent months, even lower risk areas. One of which now offers appealing value and a cushion against further set-backs.

30/03/2022
Hiding-in-plain-sight

Authors

Lisa Hornby
Head of US Multi-Sector Fixed Income

With the Federal Reserve (Fed) at the beginning of a hiking cycle, much commentary is focused on the potential for continued weakness in fixed income markets. As is often the case, markets try to anticipate the course of future events, and this well-telegraphed move is no exception.

So far this year, US bond yields have re-priced sharply across the curve – most dramatically at shorter maturities. US 2-year Treasury yields have risen from 0.28% to over 2.4% since the end of September. This has resulted in negative returns for bond investors, since bond prices fall when yields rise. 

It can be difficult to go against such a forceful move in markets, but following the scale of the move, this could well be a good moment to consider doing just that.

On the one hand, if markets stabilise now or yields drop, investors stand to earn greater returns than have been available for most of the last 10 years. On the other hand, there is now significant margin for error, or cushion, should a further adverse move in rates and credit spreads (difference between corporate and government bond yields) occur. 

Value in short-dated US credit yields

The Treasury market at current levels, indicates that investors expect more than 2% of rate hikes over the next 12 months.

Corporate bond spreads have undergone a dramatic re-pricing too, touching 1.14% on the ICE BofA 1-3 Year US Corporate index, roughly 75 bps higher over the last six months.

Therefore, the yield on the short maturity, investment grade corporate index is just over 3%, an increase of 2.3% from one year ago.

Yields can always go higher still, which would push prices down further. If markets do end up pricing in more rate hikes, we can use the “breakeven yield” as one measure of potential downside risk.

This is the level to which bond yields would have to rise in order for capital losses to offset the income earned over 12 months, resulting in a zero return. This varies by starting yield and bond maturity.

Yields for the 1-3 Year US Corporate index would have to rise to almost 4.5% – well above the last 10-year high of 3.65% – for investors to make no money. 

Short-dated-corporate-yields-provide-cushion

Hiding in plain sight?

The balance of risks is now much more attractive at these levels. Added to this, there are a number of reasons the Fed may not be able to complete the rate hikes the markets have priced. If that turns out to be the case, yields will likely fall and prices rise, and investors will be able to earn more than the carry implied by current yields.

Amid a multitude of highly uncertain factors, not least the abhorrent war in Ukraine, it is natural to look for safer haven assets. Short-dated corporate bonds arguably deserve consideration, since they offer the prospect of resilience and stability, underpinned by income.

Since 1980, US 1-3 year corporate bonds have only experienced one annual decline of any significance, returning -2.7% in 2008. Last year, owing to a late sell-off, the index was flat. 

A key reason for this consistent positive performance has been the effect of interest or coupon income from the bonds. In seven of the last 10 years, negative price returns, due to rising yields, have been more than offset by income returns. In 2011, for instance, prices fell -2.8%, but the index delivered a total return of 1.8%.

This is illustrated in the chart below. Year-to-date, the rise in 2-year yields has occurred so quickly that income has not yet had a chance to offset it.

Two-year-yield-change-versus-short-dated-corporate-bond-returns

Another factor behind its resilience as an asset class, is its price sensitivity to changes in rates is relatively low. This is measured by duration, which gives an indication of expected price moves per percentage point move in yields.

For 1-3 year corporate bonds the current duration level is 1.8, so a 1% fall in yields would result in around a 1.8% rise in prices, and vice versa. Duration is affected by maturity so, by comparison, the duration for the ICE BofA 3-5 Year US Corporate Index is 3.6 years. That makes it twice as sensitive to changes in interest rates than the 1-3 year index.

Could yields stabilise from here?

We see four reasons that yields could start to find support following this sell-off.

  1. Growth had already been decelerating from the breakneck speed of recovery from the depths of the pandemic.
  2. Fiscal and monetary boosts are being withdrawn and this will weigh on the consumer, and in turn growth.
  3. The erosion of real incomes from inflation looks to be sustained with ongoing energy and commodity spikes flowing from the war in Ukraine.
  4. Global decoupling could continue, or even escalate, creating further headwinds for economic growth.

Authors

Lisa Hornby
Head of US Multi-Sector Fixed Income

Topics

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