Fixed income in 2024: Income, capital appreciation and diversification

As 2023 drew on, our motto became “Bonds are back” because fixed income markets offered their most attractive yields in 20 years. Now, we may have to adjust that motto to say, “Bonds are back – get them while you can!” The rally in bond markets at the end of 2023 was considerable and probably stemmed from some of the return opportunities for 2024 being pulled into 2023. That said, we still think fixed income offers a compelling opportunity now that inflation has stabilized, economic momentum is slowing, and yields remain elevated relative to recent history. Bonds also look attractive versus other asset classes, namely equities, with the equity risk premium at a 15-year low. It seems the market is anticipating something close to perfection for 2024, with economic growth expected to slow enough for the US Federal Reserve (Fed) to cut rates, but not enough to prevent a significant acceleration in earnings growth. One thing that we can almost be certain of, 2024 will surprise markets in some way. As always, we will look to valuations as our beacon to guide us through the haze.

Despite the rally at the end of last year, fixed income assets are still close to decade highs (Figure 1). After several years of significant rate volatility, it seems likely that rates have reached their peak, and we expect they will be more stable going forward. The question now is not IF the Fed will cut rates but WHEN. We believe this should lead to attractive income and capital appreciation opportunities, especially across some of the higher quality segments of the market.

Figure 1: Index yields ranked over time

^{1.) 100th percentile is most attractive; 1st is the least .}

^{Source: Bloomberg and ICE BofA as of December 31, 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. Past performance provides no guarantee of future results and may not be repeated.}

In the event that growth does slow more than predicted, the Fed could initiate a rate-cutting cycle that would be much more significant than what is currently discounted. History shows us that the market typically underestimates the magnitude of a rate-cutting cycle. In addition, Treasury bond rallies historically have begun prior to the final rate hike and last for an average of 26 months after yields have peaked (Figure 2). One common question we receive is whether it is too late to invest in bonds. The short answer is no. Looking at previous rate-cutting cycles over the last 30 years, the average fall in the 10-year Treasury yield has been around 50%. This is not a prediction but provides some context. Given the peak in yields was 5%, that suggests there is still some runway for bonds to perform, with the potential for material capital appreciation if the Fed embarks on a substantial rate-cutting cycle.

Figure 2: Rallies begin prior to a final hike and last well into easing cycle

Yields rally for 26 months on average after reaching their peak

10yr Treasury Yield v. Fed Funds target rate (in %)

^{Source: Bloomberg, Schroders as of December 31, 2023. Past performance provides no guarantee of future results and may not be repeated. Shown for illustrative purposes only and should not be interpreted as a recommendation to buy/sell any security or adopt a particular investment strategy.}

Finally, after highly elevated (and unusual) correlations between stocks and bonds, it is reasonable to expect correlations to return to more historically normal ranges. Bonds may not act as a perfect hedge to equities, but we do expect them to provide a diversification benefit once again (Figure 3).

Figure 3: Diversification benefits even if correlations are positive

Positive correlation in 2022 and Q1 2023 was elevated even for high inflation periods

^{Source: Bloomberg, Schroders as of December 31, 2023. Average 12-month rolling total return correlations between S&P and notional 10-year US Treasury when inflation over the 12 months was in range indicated. Shown for illustrative purposes only and should not be interpreted as investment guidance. Current performance trends may not continue and are not a guide to future results. Diversification cannot ensure profits or protect against loss of principal.}

When we compare the various sectors of the fixed income market on a spread basis, we see different opportunities. In our view, the higher-quality/lower-risk segments of the market, such as short-dated investment-grade corporates, agency mortgage-backed securities (MBS), asset-backed securities (ABS) and Treasuries offer the best value. We believe long-dated tax-exempt municipal bonds may deliver value for tax-payers, but offer limited opportunities for those without considerable tax obligations. Other segments of the market, including dollar-denominated long-dated investment-grade corporates, emerging market sovereigns, and high yield corporates appear to be close to fully priced, in our view. Spreads on these sectors are close to their historical tights (Figure 4). In the past, the opportunities for investors to realize positive excess returns in the aftermath of such narrow spreads tended to be close to zero. That suggests portfolios should be positioned with a degree of caution when it comes to these sectors.

Figure 4: Opportunities in certain sectors, while others look expensive

Looking for opportunity in high quality, cautious on riskier assets

Current percentile of option-adjusted spread for various spread sectors over the past 10 years

^{Source: Schroders and Bloomberg; as of December 31, 2023. Indices used are the Bloomberg US Corporate Index, Bloomberg Long US Corporate Index, Bloomberg Corporate High Yield Index, Bloomberg Emerging Markets USD Aggregate Bond Index, Bloomberg US Mortgage Backed Securities (MBS) Index, Bloomberg Asset-Backed Securities Index, Bloomberg US Aggregate CMBS Index, and the ICE Bank of America Broad US Taxable Municipal Securities Index. Municipal data uses the AAA municipal yield as a percentage of the 30-Year Treasury yield. Security types shown for illustrative purposes only and should not be viewed as investment guidance. Past performance is not a guide to future results.}

The stage seems set for a rebound in securitized assets

The securitized sector continues to be a favorite of ours, and it was an area in which we materially increased allocations over the course of 2023. The sector offers a combination of generous valuations, solid fundamentals and improving demand, which has provided a good place to deploy capital in an environment where growth is slowing and corporate valuations are ordinary.

The sector, agency MBS in particular, suffered from various ills throughout 2022 and 2023, including elevated interest rate volatility (which was bad for agency MBS as these securities are inherently “short” an option), the Fed’s quantitative tightening (QT) program (resulting in more supply and less demand), and a regional-banking crisis (that resulted in less demand). The result was that agency mortgages, as measured by the Bloomberg US Mortgage Backed Securities Index, materially underperformed other high-quality assets – delivering excess returns of +0.68% for the year, considerably trailing investment-grade corporates, which, as measured by the Bloomberg US Corporate Index, delivered excess returns of +4.55% over the same period. The spread differential between corporate bonds and agency MBS is at its lowest level in over 25 years (Figure 5).

Figure 5: Mortgage spreads versus corporate spreads (in bps)

^{Source: Bloomberg, using monthly data. Current performance trends are not a guide to future results.}

Higher coupon mortgages led the underperformance, and this segment of the market has been the focus of our agency MBS trade. In our view, this segment offers opportunity, particularly as we see some of the factors that led to its weakness starting to reverse. Interest rate volatility is off its highs, and we believe this will continue to decline. More importantly, we see some catalysts in place that could propel banks to return to the market as a buyer. In addition, there is talk about the Fed ending the quantitative tightening (QT) program mid-2024. While it may continue to reduce its mortgage balances, the winding down of QT could support bank deposit growth, and that could increase demand for agency MBS as banks put those deposits to work.

In the fourth quarter of 2023, we favored the short-dated ABS sector. Spreads in the sector came under pressure, along with those of agency MBS, and we saw this development as an opportunity. High-quality, AAA-rated auto ABS were trading at spreads approximately three times wider than their usual levels. The sector has virtually no negative convexity and no default risk because of its highly overcollateralized and credit-tranched capital structure. In addition, the sector looked cheap to us, relative to lower-rated, short-dated corporates. Excess returns in the sector, as measured by the Bloomberg ABS Auto AAA Index, were 82 basis points (bps) for 2023, as compared with 180 bps for short-dated corporates, as measured by the Bloomberg US Corporate Bond 1-5 Year Index.

Another sector we found attractive this past year was the longer, highly liquid agency commercial mortgage-backed securities (CMBS) sector, namely Freddie K 10-year bonds. In our view, spreads on the AAA-rated Freddie Ks were cheap relative to similar duration, lower-rated corporates. This was an opportunity to add another sector that has no negative convexity due to the pre-payment penalties on the underlying collateral and no credit risk given that it is agency-backed collateral.

Attractive all-in yields but expensive spreads in the corporate bond market

On the corporate side, all-in yields look highly attractive to us, while spreads appear to be expensive. This suggests that total returns could be strong in 2024, while the excess returns that corporates generate over Treasuries may be more disappointing. As of year-end 2023, spreads on US corporate bonds, as measured by the Bloomberg US Corporate Index, were at the 23^rd percentile over the past 5 years and the 17^th percentile over the past 10 years, while spreads in the high yield segment, as measured by the Bloomberg US Corporate High Yield Index, were comparably tight, at the 19^th and 11^th percentiles for the past 5 and 10 years, respectively. If economic growth remains resilient, spreads could stay rangebound or even tighten marginally. However, if higher rates finally start to impact the broader economy or if another external credit shock occurs (such as the March 2023 regional banking crisis), we expect credit spreads could widen materially. This asymmetric risk profile keeps us cautious.

In terms of corporate fundamentals, credit metrics are deteriorating, in our view, but they are doing so from a strong starting point. Over the course of 2023, we saw leverage metrics and interest coverage weaken as earnings moved lower while debt levels shifted higher. Companies, however, have been reasonably protective of their balance sheets and generally curtailed shareholder-friendly activity, a positive for the bondholder community (moves to buy back stock or increase dividends only raise bondholder concerns when such steps might weaken balance sheets). The massive fiscal stimulus over the past few years­–coupled with low rates, which have allowed companies to lock in low fixed-rate loans–has extended the runway for higher rates to impact fundamentals. However, if rates stay higher for longer, and/or fiscal support for the economy fades, the risks to corporate fundamentals could rise.

From a technical perspective, we think net supply within the investment-grade space will be supportive for this sector this year as much of the expected issuance will be offset by coupons and maturities. In our view, demand should remain strong going into a Fed easing cycle, especially as money rotates out of cash-like assets and the high funding status of corporate pensions continues to support the demand for long-dated fixed income investments. The direction of interest rates will be an important driver of credit spreads, as higher yields are likely to draw in more buyers (including sponsors of defined benefit plans), while lower yields would prevent some from allocating.

While fundamentals and technicals should remain supportive, our view is that investors should position up in quality and down in cyclicality given today’s starting point in spreads along with risks to the macro backdrop and systemic risk considerations. There will likely be better opportunities to invest in the corporate sector, given the current asymmetry in spreads. Where we still favor credit, we are focused on short and intermediate maturities, which benefit to a greater degree from positive carry, and we find little reason to go out further on the yield curve because curves across all credit sectors are now flat, given strong demand and low supply on the long end.

Looking across the corporates universe, we continue to find opportunities within some of the sectors that have lagged, such as banking, communications and energy. Financials have remained cheap relative to non-financials, largely driven by technicals, and in our view this represents a compelling opportunity. Within financials, we are focused on the largest, most diversified banks such as the US global systemically important banks (G-SIBs) and super-regionals (that is, those with $250 billion or more in assets). While Yankee banks appeared particularly cheap in 2023, they have rallied substantially, and we have reduced Yankee exposure into US issuers. The communications industry also appears to have cheaper valuations and some of our core holdings have been focused on balance sheet management and repair (measures such as buying back debt). Energy also represents an opportunity in our view, as a result of some of the long-term structural supports for the sector. Increased geopolitical tensions should also put a floor under energy prices, and this could ultimately benefit the sector. Within this space, our focus is on the midstream segment, which trades wide to the credit index and where leverage metrics have generally improved as issuers have been focused on balance sheet preservation for the last few years. More broadly, we continue to favor issuers that have high cash balances relative to their debt burdens and the ability to weather a more challenging macro environment, given the tight overall spreads and relatively low dispersion in market valuations.

The municipal market offers selective opportunities but valuations are full

In 2023, the broad municipal market, as measured by the Bloomberg Municipal Bond index, delivered positive total returns of 6.40%. We anticipate that returns in 2024 will be modestly positive and more carry-like. However, it is important to note that a slowing economy could result in increased use of reserves by municipalities and a gradual decline in credit fundamentals.

As we have written in the past, retail demand for municipals tends to fluctuate based on expectations of interest rate movements. Currently, the market has priced in more rate cuts than what the Fed has signaled. As the retail market adjusts to the possibility of fewer cuts, we anticipate a cheapening of the now expensive municipal to Treasury yield ratios. From a valuation perspective, we see opportunities in sectors with wider spreads and different structures, such as municipal-supported housing bonds and corporate-backed municipals, as well as the long end of the market. However, we believe there is less value in the generic municipal market, where spreads to the AAA-rated municipal scale are compressed.

In terms of general market trends, upgrade-to-downgrade ratios and outlook changes remain relatively stable across the market. However, we anticipate a weakening of these trends over the next few quarters. Negative outlooks are particularly prevalent in the health care and higher education sectors. The deployment and pace of federal pandemic support spending varies across the country, and that provides some buffer for credit fundamental declines with a slowing revenue base.

During election years, it is common to observe a front-loading of issuance, and that results in a heavier supply of securities in the first half of the year. This increased supply, combined with the possibility of fewer rate cuts than what the market has currently priced in, may put downward pressure on municipal valuations. However, as the year progresses and Fed cuts materialize, retail money in money market instruments and certificates of deposit (CDs) should provide supportive inflows for separately managed accounts (SMAs) and exchange-traded funds (ETFs). One notable development that may impact the municipal bond market in 2024 is the unexpected shutdown of Citibank’s municipal bond desk. This event is likely to contribute to increased volatility. The date of the shutdown has been accelerated from the second to the first quarter of 2024, a development that surprised many market participants.

From a sector perspective, we favor shorter-maturity structured products, such as municipal-supported housing bonds and corporate-backed municipals. We believe these sectors offer comparatively cheap valuations relative to their overall risk. Municipal-supported housing bonds, similar to federal agency MBS, exhibit a better convexity profile because of less frequent prepayments. Corporate-backed municipals involve municipalities pre-funding their natural gas purchases and offer bonds with unconditional guarantees from financial institutions that trade at a material after-tax advantage over the backing institution's corporate debt. In terms of longer maturities, we favor property tax-backed general obligation school bonds. This sector appears to us to be stable from a fundamental perspective, with strong assessed property values and stable property tax collections. These factors, collectively, make the sector an attractive investment opportunity, in our view.

Conclusion: A time for selective optimism

Fixed income markets today offer a compelling opportunity from an income perspective. Despite the rally, nominal yields remain toward the upper end of their 10- and 20-year ranges. Given the changing Fed and macroeconomic backdrop, they also have the potential to generate significant capital appreciation and diversification away from other sectors. From a spread perspective, we are positive on some sectors and negative or cautious on others, depending on the maturity and quality considerations within each sector. High-quality securitized products, Treasuries and short-maturity investment-grade corporates seem highly attractive to us today. For tax-paying investors, the same nuances apply: short-maturity structured tax exempts and long-dated general obligation bonds stand out as the most attractive. Maintaining liquidity is also important in this market, as we want to be prepared for any unforeseen increases in volatility, whether these be Fed-induced or caused by other unexpected events.

Any reference to regions/ countries/ sectors/ stocks/ securities is for illustrative purposes only and not a recommendation to buy or sell any financial instruments or adopt a specific investment strategy.

Important information

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. All investments involve risk, including the loss of principal.