Asset Class in Focus: Fixed Income

Asset Class in Focus: Fixed Income

The benchmark 10-year Treasury bond now yields less than 1.5%[1], while the Consumer Price Index (CPI) shows inflation running much higher than that. Even if you assume that the recent uptick in inflation reflects temporary supply chain and labor market disruptions, there are reasons to believe that interest rates will move higher in the not-too-distant future. Given that bond prices fall when interest rates rise, what role should fixed income play in investors’ portfolios today?

 

Back to Basics: Understanding Interest Rate Risk and Credit Risk

Before we answer that question, it may be useful to review some bond market basics. Investors may think of bonds as a single, homogeneous asset class. In reality, there are many different types of bonds, with varying exposure to the two main risks in fixed income: interest rate risk and credit risk.

  • Interest rate risk is largely a function of the number of years remaining until a bond matures. When interest rates rise, prices of bonds with many years left to maturity will fall more than prices of short-term bonds. This reflects the concept of duration, a measure of a bond’s sensitivity to changes in rates. To compensate investors for interest rate risk, long duration bonds usually offer higher yields than similar bonds with shorter durations.

  • Credit risk (also known as default risk) reflects the possibility that a bond’s issuer may not be able to pay interest and repay principal on time. Investors demand a higher yield on bonds with greater credit risk than they would for a “risk-free” (non-defaultable) Treasury bond with the same time to maturity. The greater the credit risk, the higher the yield relative to a risk-free equivalent.

 
Exposure to these risks largely determines what types of bonds are a potential match for a given investor. Here, we briefly summarize interest rate risk and credit risk for three major categories of bonds.

  • U.S. Treasury securities: With maturities ranging from one month to 30 years, Treasuries have varying levels of interest rate risk. Treasuries have no credit risk and are the “risk-free” benchmark for other bonds. Treasury Inflation-Protected Securities (TIPS) protect investors from inflation and therefore have less interest rate risk than regular (“nominal”) Treasuries.

  • Corporate bonds: Corporate bonds have interest rate risk, ranging from ultra-low (maturing in the near term) to high (maturing in 30 years or more). They also have credit risk due to the chance that the issuing company doesn’t perform well and defaults on its debt. There are two broad credit risk categories for corporate bonds: investment grade and high yield. The former applies to bonds with credit ratings of BBB- or higher; the latter covers bonds rated below BBB-. As you might expect, high yield bonds offer a higher yield than investment grade bonds to compensate investors for the greater risk of default.

  • Municipal bonds: Like corporate bonds, municipal bonds (commonly referred to as “munis”) have interest rate risk and credit risk that range from very low to quite high depending on the time to maturity and the financial health of the issuing city, county, state, or other governmental entity.

 

What Goes Down Must Come Up?

Bonds have been in a bull market for the past four decades. The 10-year U.S. Treasury yield declined from a high of almost 16% in the early 1980s to less than 1% in early 2020 (see graph below). As a reminder, as bond yields go down, prices go up, so bond investors saw consistently strong fixed income returns over this time period. This extended bull market for bonds now appears poised to end, as interest rates essentially have nowhere to go but up.

 

10-year U.S. Treasury yields, January 1980 to September 2021[2]

 
Chart of 10-year U.S. Treasury yields, January 1980 to September 2021
 

The credit risk landscape in the corporate bond market has also changed. Investors’ search for yield has led many companies with less-than-robust balance sheets to issue new bonds. As a result, the entire investment grade corporate bond market has shifted lower in quality. Slightly more than 50% of investment grade bonds are now rated BBB, which is just one rating category above non-investment grade (or high yield) bonds. In 1990, only about 18% of investment grade bonds were issued with a BBB rating.[3]
 
In a typical recession, the ratings on some of these BBB-rated bonds will drop, moving them into the high yield category. Many mutual funds and other institutional investors will be forced to sell those bonds because of investment policies that prevent them from holding non-investment grade bonds, negatively affecting such bonds’ prices.

 

The Role of Fixed Income in a Portfolio Today

Bonds provide a cushion in the event of a downturn in equity markets. Allocating some portion of a portfolio to high-quality bonds that are more resilient in a recession allows investors to avoid selling equities in a down market, and that concept still holds true today. It is important, however, to consider how much duration and credit risk is appropriate for each individual investor in today’s environment, and how much of a fixed income cushion is needed.
 
Because interest rates are expected to rise, many investors are choosing to keep duration and credit risk fairly low using investment grade corporate bond funds. Note that funds buy bonds in large quantities and therefore get better pricing than an individual investor can. Some corporate bond funds hold only floating rate bonds for which coupon payments adjust when rates rise and fall. They have very low interest rate risk but often higher credit risk.
 
Low-rated high yield bonds can be more sensitive to equity markets than to interest rates, as the issuer’s stock price signals the likelihood of a default. In our opinion, in-depth credit research is critical in the high yield space, so it typically pays to use actively managed funds for high yield exposure.
 
Many investors may prefer to hold cash for safety instead of fixed income. But keep in mind that holding too much cash that pays a guaranteed 0% return is risky, too. After subtracting inflation, investors are earning a substantially negative yield on cash today. High quality, short duration bond funds, on the other hand, yield 1% or more and can be sold to generate cash if needed. In a market downturn, that cushion allows investors to leave equity positions untouched while the market recovers. This highlights the importance of assessing your need for liquidity in the next one to three years and working with your advisor to determine the fixed income exposure that is best for you.
 
To learn more about the role that fixed income can play in your portfolio based on your unique goals and circumstances, contact your BDO wealth advisor.

Have Questions? Contact Us

 

[1] U.S. Department of the Treasury, Daily Treasury Yield Curve Rates, accessed on September 26, 2021
[2] Federal Reserve Bank of St. Louis, 10-Year Treasury Constant Maturity Rate, January 1, 1980 through September 29, 2201
[3] Çelik, S., G. Demirtaş and M. Isaksson (2020), “Corporate Bond Market Trends, Emerging Risks and Monetary Policy ”, OECD Capital Market Series, Paris