Investors are reassessing how to position fixed income portfolios after a period of major macroeconomic transition, say Xavier Blaiteau and Mathias Neidert of bfinance.
There’s no shying away from it, the past 18 months have been particularly challenging for fixed income investors. In 2022, an extended equity market downturn coincided with negative performance in the US Aggregate bond index for the first time since the 1970s – a historic, diversification-defying result. Meanwhile, the UK pension fund ‘LDI crisis’ of 2022 and the ‘banking crisis’ of 2023 have highlighted the potential damage to balance sheets and financial systems when theoretically low-risk fixed income assets depreciate.
Today, catch-22 scenarios abound for bond investors as policymakers waver between the need to combat inflation through interest rate hikes and the desire to mitigate recessionary forces. Amid a period of uncertainty and re-evaluation, it can be beneficial to interrogate some of the received wisdom surrounding fixed income and its performance through periods of rising interest rates, recessions, or both. Below, we look at three popular beliefs about the performance of fixed income during periods of rising interest rates and in recessions.
● Popular belief 1: Fixed income does poorly when interest rates are rising
The recent rate-hike cycle has produced significant losses in US Treasuries and investment grade credit. Indeed, these sectors do often generate flat-to-negative performance in periods of rising yields. Yet rate rises do not necessarily spell bad news for fixed income as an asset class: a number of sub-sectors have historically provided moderate-to-strongly-positive returns during such phases, such as short-duration credit.
That being said, there are several factors driving stronger and weaker performance and those characteristics are changing over time. The first is spread compression, which can often compensate for rising rates: we did not in fact see spread compression in 2022, due to already-low spreads and the increasing credit quality of the US high yield index. The second is coupons, which can meaningfully offset negative price movement: coupons in investment grade credit were at low levels, while average coupon sizes had already declined in the high yield index due to higher credit quality, meaning that the buffer effect was reduced. The third key factor affecting performance is the current duration profile of the market or portfolio: happily (for today’s investors), duration tends to decrease mathematically as yields rise, meaning that subsequent rate rises become less damaging than earlier rate rises would have been.
● Popular belief 2: Investment grade beats high yield in recessions
Received wisdom for recessionary investing is to favour higher quality, longer duration asset classes. Indeed, the very brief recession of 2020 saw US high yield bonds underperform US stocks. Yet historical data suggests that the performance of high yield bonds is not as bad as you might suspect: it is not necessarily true that this sector will suffer heavy losses during periods of economic decline.
However, high yield debt resilience is largely due to stronger performance during the later stages of recessions. Recessions tend to consist of an earlier period when risk assets are broadly in retreat (a shift which tends to start long before an extended economic decline is seen) and a period when risk assets, including high yield bonds, are resurgent. Just as investors can theoretically benefit from a recession-oriented approach long before the recession is visible, a recovery-oriented approach is typically helpful before the recovery is evident.
The risk-on shift tends to take place well before the real economy emerges from recession. It is often linked to central bank rate cuts that are designed to encourage growth; investors should be cautious of inflationary conditions that obstruct central bank stimulus.
● Popular belief 3: Short duration fixed income is less volatile than long-duration bonds
Short duration bonds often outperform during rising rate periods, show resilience in recessionary conditions and—overall—produce lower volatility and better risk-adjusted returns.
Shorter duration fixed income has underperformed versus the wider market for most of the past decade, but produced superior risk-adjusted returns due to its lower volatility. Indeed, it tends to perform best at the times when investors are most in need of resilience.
In 2022, short duration fixed income provided investors with particularly strong protection at the time the Fed was implementing consecutive rate hikes. While US investment grade credit lost 12.3% between July 2020 and December 2022, short-duration investment grade credit (1-3 year) only lost 2.6%. Meanwhile, US high yield only gained 4.3% during this period, while short-duration high yield (1-3 year) gained 13.1%.
However, bad debt may crowd the short-duration high yield market at times of credit stress. Issuers like to call their debt ahead of maturity, but companies whose financials are deteriorating may struggle to call their bonds and prefer to let them run until maturity (this is not technically a default, of course). In such scenario, stressed issuers gradually represent a larger part of the short-duration bond market as high-quality issuers refinance their debt with longer-dated issuance and exit the short duration space. For this reason, asset managers running short-duration high yield portfolios tend to exclude CCCs and/or underweight more cyclical sectors such as energy to ensure that they deliver a relatively low-risk profile.
No ‘silver bullet’
Inflation, interest rates and recessionary forces are creating difficult questions for today’s fixed income investors: there is no silver bullet or optimal portfolio positioning as we chart a course through current conditions. Yet it is important—always—to beware presumptions about performance. Past results can support expectations for fixed income amid certain scenarios, but it is also crucial to consider the ways in which the market has changed and understand the characteristics or variables that may have influenced previous results.
*Xavier Blaiteau is director, fixed income, and Mathias Neidert is head of public markets at bfinance.
