A revolutionary opportunity in bonds in the face of challenging returns
The bear market in bonds has persisted for three years, with yields rising since the summer of 2020. As a result, US Treasury returns have been the worst since the United States ratified its constitution in 1787. Bond investors may feel battered and bruised, but we believe it would be a mistake to give up on the asset class. With growth and inflation slowing down and the Federal Reserve (Fed) nearing the end of their hiking cycle, historically this has been a rewarding time to invest in bonds.
While the recent returns have been sobering, they have also created opportunity. Despite inflation being more elevated than the previous decade, yields - both real and nominal - on higher quality bonds now stand at their highest levels in 15 years. This not only makes them screen cheaply in absolute terms, but also relative to other asset classes, particularly equities (Figure 1). Additionally, with growth and inflation slowing, and the Federal Reserve (Fed) at or approaching the end of their hiking cycle, historically this has been when investing in bonds has been the most rewarding.
Figure 1: Bonds offer value versus historically rich equities
Source: Bloomberg, Schroders as of September 30, 2023. Economic indicators and related historical trends should not be solely relied upon to predict future results.
Putting returns into perspective
The drawdowns we have experienced over the last three years in the Treasury market are not just unprecedented but have been the worst on record. The magnitude of these drawdowns can be attributed to three key factors. First, the low starting point in yields provided minimal income to offset capital losses. Secondly, the Fed’s most aggressive calendar year hiking cycle on record added further pressure. Finally, the fallout from the pandemic resulted in the highest inflation in 40 years. When comparing the returns of various asset classes, you can see fixed income has been a conspicuous laggard (Figure 2). The drawdown of fixed income relative to equities and commodities is particularly stark.
Figure 2: Total cumulative returns since August 2020 and the first hike in March 2022
Source: Bloomberg as of September 30, 2023. Past performance is not a guide to future results and may not be repeated.
The disappointing returns of the last three years are now in the history books. As we turn the page and start a new chapter, we must shift our focus towards the opportunities that lie ahead. In terms of valuations, both in an absolute sense and relative to other asset classes, bonds screen as cheaply as they have in the last decade and in the top quartile (most attractive) over the last 20 years (Figure 3). That doesn’t mean a rally is necessarily imminent, but the higher yields do offer a significant cushion in terms of income to offset any further price declines.
Figure 3: Yields ranked over time
Source: Bloomberg and ICE BofA as of September 30, 2023. Indices used: Bloomberg US Aggregate Index, Bloomberg US Treasury Index, Bloomberg US Long Treasury Index, Bloomberg Securitized Index, Bloomberg Municipal Index, Bloomberg US Corporate Index, ICE BofA US Corporate 1-3 Year Index, Bloomberg US Long Corporate Index and Bloomberg US High Yield Index. Economic indicators and related historical trends should not be solely relied upon to predict future results. Shown for illustrative purposes only and should not be interpreted as investment guidance.
Secondly, bonds don’t only look cheap relative to their own history, but they also screen attractively when compared to other asset classes, such as equities. Figure 4 illustrates the unprecedented magnitude of the drawdown in bonds, particularly when contrasted with the resilience demonstrated by riskier asset classes. The chart below, which plots the equity risk premium over the last 15 years, underscores the current attractiveness of Treasuries as compared to equities. The equity risk premium represents the additional return an investor expects to earn by investing in equities compared to Treasuries. As you can see, the valuation for the “risk-free” 10-year Treasury is as attractive relative to equities as it has been since the just prior to the Global Financial Crisis.
Figure 4: Equity risk premium (30-day moving average)
Source: Bloomberg as of September 30, 2023. Equity risk premium is calculated using the S&P 500 Index forward earnings yield minus the 10-year Treasury yield. Economic indicators and related historical trends should not be solely relied upon to predict future results.
While these factors in isolation don’t mean a reversal is imminent. it does highlight how the hurdle now for fixed income assets to post negative returns from this point forward has declined meaningfully as higher yields provide a cushion for any price decline. Additionally, if economic growth slows or risk aversion increases in the coming months, there is the potential for outsized returns. Figure 5 below shows the impact of higher rates on US Aggregate bonds. As you can see, given the high starting yield, returns remain positive over one and three-year periods even if rates continue to rise. Furthermore, in the event of a decline, the potential returns move into the realm of high double-digits.
Figure 5: Scenario analysis
Source: Aladdin® data is used as of September 30, 2023 for yield / OAD / Muni OAD and key rate duration distribution; Bloomberg for treasury forward yields. Assumes parallel yield curve shift. Shifts are applied to current yield curve. Shifts shown are added to yield changes implied by treasury forward rates. Yields are assumed not to go below zero. Portfolio characteristics (other than valuation yield related characteristics) are assumed to remain constant (not equivalent to a buy and hold strategy). Portfolio characteristics (Annual Yield and Effective Duration) are used to project the expected total return given the specific interest rate shifts. The shift in interest rates is assumed to be equal across the Treasury curve and occurs incrementally over the time horizon. Annual Yield is the annual yield to worst. We generally adjust the duration of tax-exempt municipal bonds by a factor (currently 0.7) to reflect our view that prices are typically less sensitive to changes in interest rates than taxable securities. Total Return numbers are the result of geometric compounding. Results are purely illustrative only and may not be realized. Past performance is not a guarantee of future results. The value of an investment may go down as well as up and is not guaranteed. Performance is stated gross of fees.
Recession, soft landing, no landing?
The US economy has shown remarkable resilience over the last 18 months despite a number of a headwinds. In the face of the most aggressive rate hiking cycle witnessed in a generation, markets have grappled with a regional banking crisis, soaring energy costs, a persistently strong dollar, and geopolitical uncertainty. In our view this strength can be attributed to two primary factors: the drawdown of consumer excess savings accumulated during COVID, which has rapidly diminished from its peak of $2 trillion, and the implementation of federal investment programs. The CHIPS and Science Act (approximately $280 billion) and the somewhat ironically named Inflation Reduction Act ($781 billion) were both signed into law in 2022. These programs have not only directly influenced spending patterns, but have also spurred a significant uptick in business investment, as depicted in Figure 6. As evidenced below, construction spending for residential and non-residential projects has increased by 167% since the outbreak of Covid in early 2020.
Figure 6: US construction spending manufacturing, seasonally adjusted, in trillions
Source: US Census Bureau as of August 31, 2023. Economic indicators and related historical trends should not be solely relied upon to predict future results.
It is important to note that the tailwinds provided by these factors over the past 18 months are unlikely to be replicated in the coming quarters. Furthermore, the full effect of the “long and variable lags” associated with monetary policy, as acknowledged by the Fed, has yet to be fully felt. With over 500 basis points in rate hikes since the beginning of 2022, bond yields have more than tripled. In a highly indebted economy, it would be a rather optimistic assumption to believe that there will be no unintended consequences.
“There is no post-1950 precedent for a sizable central-bank-induced disinflation that does not entail substantial economic sacrifice or recession1.”
In fact, we are already seeing some of the consequences of higher interest rates. Financing costs for businesses have continued to move higher in response to the increasing Fed Funds rate. Additionally, credit conditions will continue to tighten as the banking sector contends with weaker profitability, tougher capital rules and declining demand. These factors are curtailing loan growth, particularly among smaller banks. Overall commercial lending fell 2% this year through Q3 compared to an 11% gain a year earlier.
The Senior Loan Officer Opinion survey, shown in Figure 7, is focused on assessing changes in the demand for bank loans to businesses and households over the previous three months. It has historically served as a reliable lead indicator for growth and as you can see, the survey results are approaching levels last reached during the pandemic and the Global Financial Crisis of 2008. The full impact on soaring interest costs and tightening lending standards will continue to reverberate throughout the economy in the coming quarters.
Figure 7: Senior Loan Officer Opinion Survey v. US GDP (inverted 2Q lag)
Source: Bloomberg, Schroders as of September 30, 2023. Economic indicators and related historical trends should not be solely relied upon to predict future results.
The result of higher interest rates is further evident in the ballooning Federal interest costs, with the Congressional Budget Office (CBO) projecting $663 billion in annual interest payments for fiscal year 2023, double the level in 2021. Current projections from the CBO indicate that annual interest payments are expected to hit a whopping $1.4 trillion by 2033. We could write extensively on the US fiscal situation, but the key takeaway is that higher interest costs for consumers and corporations act as a longer term drag on growth and hinder productive capital investment.
Moreover, we are starting to see signs of stress from the previously bulletproof consumer. With pandemic savings close to exhausted and the savings rate now back below 4%, the bottom decile since 1960, consumers are increasingly relying on debt. Credit card balances have recently reached an all-time high above $1 trillion dollars. In addition, we can see the delinquency rates on both credit card and all consumer loans have started to rise, albeit from low levels (Figure 8), which is historically a reliable lead indicator for economic trends.
Figure 8: Delinquency rates are on the rise
Source: Bloomberg, Federal Reserve as of June 30, 2023. Economic indicators and related historical trends should not be solely relied upon to predict future results.
We do not believe the soft landing versus hard landing argument is particularly informative. What is important for markets is that the rate of change for US growth is slowing with consensus estimates in 2024 now below 1%. With dwindling consumer savings, higher rates combined with higher oil, auto strikes and a congress likely to be more parsimonious, we are anticipating more challenging economic conditions in the coming months.
Difficult quarter for municipal bonds
Municipal bonds had one of the worst quarters in absolute terms, with a negative total return of -3.95%, underperforming Treasuries by 41 basis points. As a result, municipal / Treasury ratios widened across all maturities. We attributed this to one key factor: higher than expected inflation data. The net result has been retail investors withdrawing from municipal bond funds due to concerns about the potential consequences of higher Fed Funds rates and higher long-term rates. YTD outflows are -$10 billion (Figure 9), nowhere near the historic outflows we saw in 2022, but a headwind nonetheless.
Figure 9: Municipal bond fund flows across all maturities, in billions
Source: Lipper. Shown for illustrative purposes only and should not be viewed as investment guidance.
Fundamentally speaking, we are in the early stages of a return to budget deficits for the broader municipal market. States like New York and California are facing deficits that require cuts and the use of traditional municipal accounting magic, which includes borrowing from one fund to pay another. On the other hand, states such as Florida and Texas are the ballast for the broader municipal market, as they continue to see record revenue growth supported by shifting demographics. Property values play a crucial role in the municipal market with resilient home prices leading to higher tax revenues for local governments and school districts. We believe this part of the market offers the most value for both taxable and tax-exempt municipal bonds. Similar to other sectors within fixed income, we find this part of the market attractive as it is an up-in-quality trade, and one that is currently paying investors handsomely. Long duration AAA/AA+ General Obligation tax-exempt bonds are yielding 4.5%. If you compare this to taxable rates, assuming top tax rates, it would be equivalent to a 7.5% taxable yield, which is higher than the yields on India debt. For investors, we believe the trade decision is easy, buy bonds backed by what is arguably one of the most stable sources of revenues for municipal issuers, property taxes.
When will bonds rally?
Trying to pick a top or a bottom in markets on a short-term basis really is a fool’s errand. However, we can identify some of the drivers which pushed yields higher initially, as well as the precedent from previous cycles.
Here are the key observations:
- Valuations appear positive: Nominal yields are in the 100th percentile (most attractive) over the last decade and in the top quartile over the last 20 years
- A yield’s starting point matters for returns: Even if yields rise, returns will likely be positive over the next few years for short and intermediate bonds (and can be significantly so if they stabilize or fall)
- Value relative to equities is cheap: Equity Risk Premium (earnings yield minus yields on 10-year Treasuries) sits at a 15-year extreme; bond values haven’t been this attractive compared to equities since 2007
- Inflation and growth have peaked: While many expect a soft landing today, we expect lower growth and higher volatility next year
- Historically, bond yields peak roughly 12-18 months after the first rate hike, which was in March 2022. Additionally, rates tend to peak before the Fed has competed the hiking cycle.
Where to allocate capital
In terms of allocating across the fixed income universe, we recommend a more selective approach, considering the current yield levels in different sectors. Over the past few quarters, we have maintained a preference for high quality sectors such as Treasuries and agency mortgage-backed securities (MBS). Within the corporate sector, we remain focused on short duration maturities, given the inverted curve at the front end. Despite the volatility in the Treasury market, corporate spreads have been resilient, tightening 2 bps during the quarter, and remaining around their median levels of the past 30 years. As a result, we believe that there will be better opportunities to add risk to the portfolios in the coming quarters as higher rates affect the economy and slower growth begins to weigh more heavily on corporate earnings. While municipals have become more attractive over the last few months, they do not yet present a buying opportunity for cross-over investors, but should they weaken further we will be prepared to take advantage of potential opportunities. Once markets dislocate, we believe that the more liquid sectors can be used as sources of funding for higher risk assets.
We often talk about unprecedented events in financial markets, but the returns we have seen in fixed income market over the last three years truly are without precedent. With such material drawdowns, it is not surprising that some investors have been giving up on fixed income. However, as discussed above, we believe that would be a mistake. From the rubble and revulsion arises what could be the best opportunity in bonds in more than a decade. Pricing, one thing you can calibrate, is now firmly in the investor’s favor and when combined with subsiding inflation, a peaking economy and a Fed which is approaching the end of its hiking cycle, we believe a unique opportunity has emerged for bond markets.
1‘Managing Disinflations,’ US Monetary Policy Forum (February 2023).
The views and opinions contained herein are those of Schroders’ investment teams and/or Economics Group, and do not necessarily represent Schroder Investment Management North America Inc.’s house views. These views are subject to change. This information is intended to be for information purposes only and it is not intended as promotional material in any respect.