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Investment Strategy

Why a barbell bond strategy works today

Jun 5, 2023

Fixed income securities are offering returns that are hard to ignore and present a potential opportunity to not only lock in attractive yields, but also protect your portfolio against the risk of recession

The returns available from cash and many parts of the fixed income markets have been unattractive since the great financial crisis – and particularly so over the past year as the rate of inflation soared. Yet with central banks hiking interest rates at the fastest pace in decades, bond yields have risen and now offer more compelling opportunities for investors.

During 2022 the typical relationship between fixed income and equities broke down, with both markets falling at the same time. This year the traditional pattern has resumed with bonds offering inverse returns to equities when growth concerns emerge, thereby justifying their role in balanced portfolios once again. By September 2022 yields on five-year US investment grade (IG) corporate bonds surpassed the earnings yield on the S&P 500 (figure 1).

This chart shows how bond yields are once again rivalling that of equities. The y-axis shows the yield percentage and the x-axis shows a timeline from 2018 to 2023. There is a first data line showing estimated S&P Earnings yield performance over time, starting at 6% in 2018 and rising briefly to 7% before dipping through 2019 and 2020 to 4%. It begins rising again mid 2020 to 4.5% and rises sharply from end 2021 and into 2022 to 6% again. There is also a second data line showing US 3 to 5 year IG index over time, starting at about 3.5% in 2018 before taking a heavy dip until the end of 2019 before rising sharply to 4.5% and then then taking a large dip in 2020 down to 1%. At the end of 2021, the line rises sharply through 2022 back up to 6% and sits at about 5% in 2023.

Higher interest rates and concerns about the economic outlook have pushed up the yield on shorter-dated bonds. It is now possible to achieve an annual return in excess of 5% by investing in time deposits or three-month US Treasury Bills1, which are among the safest investments.

This situation raises two key questions. First, does the potential reward offered by equities adequately compensate for the extra risks involved? Second, does it makes sense to invest in bonds with a longer duration that would typically perform well during a risk-off or recessionary environment? (Duration measures the sensitivity of a bond’s price to changes in interest rates.)

While investing in very short-dated bonds is great for maintaining liquidity, there’s a risk you’ll have to reinvest at lower rates when the securities mature because with inflation starting to fade and the likelihood of recession rising, bond yields could fall. Therefore, we believe the most reliable way to avoid sharply lower cash rates in the next 12 to 24 months is to consider short-dated IG credit.

The 2022 bond market sell-off was remarkable for many reasons, in particular that IG credit underperformed high yield (HY). Typically, it’s the other way around. Companies that issue IG bonds tend to be higher quality, less leveraged and have a lower cost of funding than HY issuers. Therefore, drawdowns in IG credit tend to be shallower and shorter when economic conditions deteriorate. That was the case in 2000, 2008 and 2020 – but not in 2022 (figure 2).

This chart shows how investment grade bond yields surged in 2022. The y-axis shows the yield to maturity percentage and the x-axis shows a timeline from 2000 to 2022. There is a first data line showing US IG performance over time, starting at 8% in 2000, dipping to 6% in 2002 and then gradually rising over the following 6 years to 9% in 2008, before dipping again to 2%. It then experiences a low period of 4-5% between 2012 and 2020, at which point it rises to 20% before troughing again and finally starts to rise again to about 6% at the end of 2022. There is also a second data line showing US HY, starting at about 13% in 2000 before taking a heavy dip in 2002 to 2004, then rising a bit to 10% through 2007 and then takes a huge hike to almost 25% in 2008, before falling sharply to 8%. It then goes through a period of volatility from 2010 to 201, briefly going to 10% in 2016, then troughing from 2016 through 2020 before seeing a brief rise to12% and dipping again back to 5%. Finally it sees a rise in 2022 back to 10%.

IG credit spreads (the difference between the yield over government bonds) widened considerably in 2022. When combined with aggressive rate hikes, we think the yields available in short-dated IG bonds look particularly attractive given their comparatively low duration. We think default rates are likely going to be relatively low given that we don’t expect a deep recession and one can further reduce the risk of default by focusing on high-quality sectors, industries and issuers.

Due to high inflation and the rapid pace of interest rate hikes, IG credit underperformed HY debt for the first time this century in 2022. That was most likely as a result of the greater tightening in spreads in IG in a zero interest rate world, as well as the HY spread offering more of a cushion to rising rates. With IG having re-priced relative, one of the safest parts of fixed income markets now looks highly attractive.

An inverted yield curve brings reinvestment risk. While the yields on offer from short-dated bonds are appealing, it may be difficult to replace that yield after they mature. After all, an inverted yield curve reflects market expectations that future interest rates will be lower than today’s.

The challenge is to compare your own forecast with market expectations. If you think interest rates will be lower than the market does in the future, you should invest in bonds now to lock in the attractive yields on offer today. But if you believe rates will be higher than the market forecast, you should stay in cash, hold floating rate investments, very short-dated bonds or a liquidity fund, so you’ll be ready to invest when higher yields are available.

The market remains divided at the moment. There are those that believe inflation will be sticky and interest rates will need to go up further, which suggests remaining in cash or short-dated deposits is the best investment decision. Others believe that the Fed has already raised rates too far and that they will have to fall materially in the near future to avoid a sharp recession; that is our base case view (figure 3). That means the greater risk to us is the risk of having to reinvest at much lower yield levels 12 to 24 months from now.

This chart shows how 2022 saw the largest tightening in conditions without a recession. The y-axis shows the 12-month change in U.S. financial conditions index level and the X-axis shows selected years: 2009 was at 4.4, 2022 was at 3.8, 1984 was at 2.4, 2001 was at 2.1, 2015 was at 1.7.

The threat of recession will be influenced by how high interest rates have to go to tame inflation. In the words of Federal Reserve chairman Jerome Powell in September: “No one knows whether this process will lead to a recession or, if so, how significant that recession would be.”

We remain concerned that the market is complacent about the risks of recession. The process of unwinding 13 years of easy money – and the associated leverage – has yet to be fully felt and the recent market volatility and distress in the financial sector reminds us that balance sheet deposits are not risk free.

Typically, investors in longer-duration bonds are rewarded with higher yields for taking more risk, and they also face the potential for capital gains as interest rates fall (or losses as they rise), which is why the yield curve tends to slope upwards.

When the yield curve is inverted as it is today, shorter-duration bonds show the best headline yields and are more insulated from rising rates but are less likely to offer capital gains in the event of recession.

Given reinvestment risk is high for shorter-dated bonds, we recommend seeking the right mix of exposure to reinvestment and duration risk when holding bonds in your portfolio. We believe it makes sense to embrace duration risk not only because it helps reduce re-investment risk but also  because it protects where one holds other assets dependent on economic growth, such as equities. The balance should be driven by your investment horizon.

We believe the US economy will be in recession by early 2024 and that interest rates will need to fall faster and to lower levels than the market expects, therefore leading to capital gain in addition to the headline yield.

This chart illustrates that we think the macro outlook should favour extending duration. The y-axis shows a percentage of 1-year hypothetical returns for rolling bills and IG corporate Index (JULI). The first category is “stronger for longer” with investment grade 1 year return valued at just over 2% and rolling T-bills 1 year return estimated at just under 6%. The second category is “softish landing (FOMC)” with investment grade 1 year return valued at just over 8% and rolling T-bills 1 year return estimated at just over 5%. The third category is “Recession” with investment grade 1 year return valued at just over 10% and rolling T-bills 1 year return estimated at just over 4%. The fourth category is “Deep Recession” with investment grade 1 year return valued at just over 14% and rolling T-bills 1 year return estimated at just over 4%.

We recommend that you should consider investing in bonds with a duration to match or even exceed your investment horizon to mitigate the risk to the economy that an inverted yield curve indicates. In summary, short-dated bonds can offer the opportunity to avoid the risk of declining deposit yields, while longer dated bonds can provide protection against recession induced equity risk in addition to paying an attractive yield.

Your J.P. Morgan team is here to discuss these insights in the context of your own portfolio. Please reach out to us if you’d like to find out how you can take advantage of the opportunities in today’s fixed income markets.

1 FactSet. Data as of May 31 2023.  US 3M Treasury Bill Yield at 5.4%

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