Dovish talk raises hopes that interest rates have peaked
Fixed income investors have gone through a stressful few weeks. Since the beginning of September, government bond yields have moved sharply higher, causing spreads to widen and returns to worsen across the board.
The jump was caused mainly by financial assets incorporating the rosier Federal Reserve projections from the latest monetary policy meetings (see here ) but also as a result of expected supply moving higher on account of larger budget deficits. The devastating headlines coming out of the Middle East also prompted a rally that stopped yesterday as a result of a slightly higher than expected CPI print in the US.
In summary, a lot of volatility in underlying rates has contaminated most asset classes bringing about more tension on the already burdened shoulders of fixed income investors.
At this juncture, with yields where they are, we believe the best way of lowering stress levels is actually by carrying out a stress test on fixed income portfolios. There are an infinite number of iterations and assumptions one can make, with varying levels of sophistication, but we think the core of the conclusions can be reached by changing only a few parameters in a very simple fixed income portfolio.
Let us assume that we have a portfolio comprised of 25% in 10-year US Treasuries, 25% in $BBB corporates and 50% in $high yield. We have deliberately chosen indices in the same currency to avoid the complications and additional assumptions introduced by FX hedging. The main parameters of this hypothetical portfolio are in the table below.
Source: Bloomberg and ICE Indices, 13 October 2023
Now let's see what the one-year return of this portfolio might be under two scenarios. Firstly, let’s assume we have a soft landing. In this scenario, inflation allowing, it is reasonable to expect that the Fed and other central banks will start slowly but surely cutting rates from levels that, according to their own words, are restrictive in the context of subdued yet still positive growth. If this were the case, it is likely that rates will enjoy a mild rally. We assume US Treasuries yields rally by 50 bps in this scenario. Regarding credit, given spreads are not at historic lows and a soft landing would bring about subdued default rates, we assume that high yield spreads narrow by 100 bps, while BBB spreads do so by 30 bps.
The total one-year return of this portfolio would therefore be 12.2%, including 7.2% of carry and 5% of capital gains. The yield at the end of the period would have declined from 7.24% to 6.175%.
Secondly, let’s analyse the case of a hard landing. In this alternative scenario, we assume US Treasuries will rally by 200 bps as the Fed and other central banks cut rates relatively quickly and there is a flight to quality as expectations for default rates increase. Credit underperforms with high yield spreads widening by 500 bps, while investment grade spreads sell off by 150 bps. The total one-year return of the portfolio under these assumptions would be 6.7%, comprised of 7.2% of carry and 0.5% of mark to market capital losses. The yield would move to 8.125% by the end of the period in this scenario.
Our conclusion after looking at these numbers and trying out other scenarios, by modifying some of the parameters mentioned above, is that investors can build a diversified and balanced fixed income portfolio that delivers income and protects the downside under very different scenarios.
It is tempting to look at the last few quarters in fixed income and conclude that things are too shaky to invest in given the attractive yields available in cash or T-bills. But a more in-depth analysis shows that under reasonable assumptions a diversified portfolio of fixed income assets might outperform cash both in a hard and a soft-landing environment. For this not to be the case, the scenario should be one where inflation starts running hot again, forcing central banks to raise rates further, while at the same time the economy does not crater and therefore the long end of the Treasury curve does not rally but sells off instead.
In other words, we would be looking at an economy that can take monetary policy rates in the 6% region and still grow relatively close to its potential growth rate. This seems highly unlikely in our view.