Insights + Resources

Five Things We’re Thankful For: Fixed Income Edition

Nov 22, 2023

There’s no doubt the last few years have been challenging for fixed income investors. And while 2023 was supposed to be the year for bonds, fixed income returns for most core bond categories have only recently turned positive for the year. That said, despite the recent challenges, we think there are several reasons to be thankful (optimistic) about the current set-up within fixed income. As such, below are five things we’re thankful for within the fixed income markets.

  • The (potential) end of the Federal Reserve (Fed) rate hiking campaign. The biggest headwind to the fixed income markets over the last few years has unequivocally been the Fed. Over the past 20 months, the Fed increased its fed funds rate by over 5%, including four 0.75% rate hikes over the course of four Fed meetings. However, with inflationary pressures abating (although admittedly still too high to warrant rate cuts), we think the Fed is likely done, which should eliminate the biggest headwind to fixed income markets.
  • The asymmetric risk/return profile for core bonds. While not unique to fixed income per se, the asset class has a feature that makes negative price performance increasingly difficult to continue due to rising rates alone. Fixed income returns are a combination of price performance and income so as yields rise, the income component increases as well. The higher income component serves as a “hurdle rate”, or a yield cushion, that will need to be eclipsed before further losses are realized. As such, these higher hurdle rates may decrease the probability of losses due to an increase in interest rates while at the same time these higher starting yields increase the probability of annual gains.

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  • The potential for equity-like returns (without equity-like risks). While our base case is for the 10-year Treasury yield to trade between 4.25% and 4.75%, given starting yields, it would not take much of a sustained drop in yields to generate high single digit/low double digit returns over a 12-month horizon for a number of high-quality fixed income sectors. For example, a 0.50% drop in yields could likely generate a 10% return (over 12 months) for AAA-rated agency mortgage-backed securities (MBS). Moreover, if the economy slows and the Fed cuts rates more than we expect next year, these high-quality fixed income sectors could generate 12%–13% type returns (no guarantees of course).

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  • The ability for income-oriented investors to generate income again. There are three primary reasons to own fixed income: diversification, liquidity, and income. And with the increase in yields recently, fixed income is providing income again. Right now, investors can build a high-quality fixed income portfolio of U.S. Treasury securities, AAA-rated agency mortgage-backed securities (MBS), and short-maturity investment-grade corporates that can generate attractive income. Investors don’t have to “reach for yield” anymore by taking on a lot of risk to meet their income needs. And for those investors concerned about still higher yields, laddered portfolios and individual bonds held to maturity are ways to take advantage of these higher yields.
  • The (historical) after-tax returns for muni investors following Fed rate hikes. While the Fed has stated an additional rate hike may be possible, munis, which can provide additional tax-exempt income in higher-rate environments, have generated attractive after-tax returns at the end of Fed rate hiking campaigns. Over the last four rate hiking cycles, munis averaged a 9.0% after-tax return over the 12-month period after the Fed was finished raising rates. Additionally, muni returns were positive in each of those periods.

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Over the past decade, interest rates were at very low levels by historical standards. Now, the recent sell-off has taken us back to longer term averages. And while the transition out of the low interest rate environment to this more normal range has been a challenging one for fixed income investors, we think the current set up for fixed income investors is a positive one. That’s not to say there won’t be volatility, there will be, but we think the risk/reward for fixed income is as attractive as it’s been in some time, for which we are thankful.

We hope everyone has a happy (and safe) Thanksgiving!

 

IMPORTANT DISCLOSURES

This material is for general information only and is not intended to provide specific advice or recommendations for any individual. There is no assurance that the views or strategies discussed are suitable for all investors. To determine which investment(s) may be appropriate for you, please consult your financial professional prior to investing.

Investing involves risks including possible loss of principal. No investment strategy or risk management technique can guarantee return or eliminate risk in all market environments. For more information on the risks associated with the strategies and product types discussed please visit https://lplresearch.com/Risks  

References to markets, asset classes, and sectors are generally regarding the corresponding market index. Indexes are unmanaged statistical composites and cannot be invested into directly. Index performance is not indicative of the performance of any investment and do not reflect fees, expenses, or sales charges. All performance referenced is historical and is no guarantee of future results.

Unless otherwise stated LPL Financial and the third party persons and firms mentioned are not affiliates of each other and make no representation with respect to each other. Any company names noted herein are for educational purposes only and not an indication of trading intent or a solicitation of their products or services.

All information is believed to be from reliable sources; however, LPL Financial makes no representation as to its completeness or accuracy.

For a list of descriptions of the indexes and economic terms referenced in this publication, please visit our website at lplresearch.com/definitions.

The Bloomberg U.S. Aggregate Bond Index is an index of the U.S. investment-grade fixed-rate bond market, including both government and corporate bonds.

Municipal bonds are subject to availability and change in price. They are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise. Interest income may be subject to the alternative minimum tax. Municipal bonds are federally tax-free but other state and local taxes may apply. If sold prior to maturity, capital gains tax could apply.

Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and bonds are subject to availability and change in price.

Preferred stock dividends are paid at the discretion of the issuing company. Preferred stocks are subject to interest rate and credit risk.

As interest rates rise, the price of the preferred falls (and vice versa). They may be subject to a call feature with changing interest rates or credit ratings.

Mortgage backed securities are subject to credit, default, prepayment, extension, market and interest rate risk.

Securities and advisory services offered through LPL Financial, a registered investment advisor and broker-dealer. Member FINRA/SIPC.

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