Bonds: Treasuries, High Quality Corporates Worth A Look After The Back-Up In Yields
November 2024
Last month ended a profitable four-month stretch for fixed income investors as yields on higher quality fixed income instruments rose sharply during October as fears of a U.S. economic slowdown or recession subsided due in large part to a series of stronger than anticipated economic data releases. For some context, the 10-year U.S. Treasury yield fell from 4.50% at the end of May down to 3.80% at the end of September, generating a 6.2% return out of the Bloomberg Aggregate Bond Index (AGG) over that time frame. But yields reversed course over the course of October, and the 10-year yield ended the month just shy of 4.30%, leading to 2.2% and 2.3% drops in the Bloomberg U.S. Aggregate Bond Index and the Bloomberg U.S. Corporate Bond Index, respectively, during the month due in large part to the longer duration characteristics of these two indices.
The 10-year U.S. Treasury holds far greater appeal now with a yield hovering around 4.4% than when the yield dipped down to around 3.6% in mid-September, but there are a few variables we believe could keep upward pressure on yields. Sovereign bond yields in the U.K. and Germany have been rising after the U.K.’s budget proposal included more gilt issuance than expected, and this could keep yields on long-dated U.S. Treasuries anchored near current levels into 2025. Stateside, uncertainty surrounding the U.S. potentially levying tariffs on a broader set of imported goods in the coming year is unlikely to dissipate over the near-term and may limit downside for yields. Also worth noting, the U.S. Treasury is potentially set to issue a larger percentage of notes and bonds in the coming year after a preference for shorter-dated bills in recent quarters. Even if one expects yields to rise, it might still make sense for income-seeking investors to consider adding exposure to longer-term bonds to lock-in these higher rates, but we would advise doing so at a measured pace given our expectation that yields could continue to climb over the near-term. This backdrop should also provide opportunities for investors to extend portfolio duration over time as opposed to deploying cash all at once, and a continued rise in Treasury yields should present investors with higher yields in investment grade corporate bonds as well should volatility bring about valuation dislocations along the way.
‘Non-Core’ Crowded But ‘Carry’ Is Still King. In October, rising rates were a drag on fixed income returns but credit fared best, as evidenced by the Bloomberg High Yield Index declining by 0.5% and easily outperforming the Aggregate Bond index by just shy of 2% on the month. High yield served as a nice diversifier for bond portfolios amid the back-up in yields last month, a trait that tends to get overlooked when investors look to ‘de-risk’ portfolios in more uncertain times as higher yields, shorter durations, and correlations take a back seat to overreaction. Another consideration for investors in core fixed income, specifically U.S. Treasuries, is growing concern surrounding larger government budget deficits. Shorter duration bonds such as corporate high yield are somewhat removed from deficit concerns due to their lower sensitivity to rising long-term Treasury yields. However, valuations for corporate high yield remain stretched and credit spreads have consistently tightened, reducing the expected return for taking on credit risk in this segment of the fixed income market. Despite lofty valuations, we don’t advise waiting on the sidelines as carry, or yield, and diversification benefits from investing in corporate bonds more than offset valuation concerns at the present time.
U.S. dollar denominated emerging market bonds returns landed between core bonds and U.S. high yield in October, with the Bloomberg USD EM Debt Index falling by 1.4% as shifts in the macroeconomic environment created volatility and portfolio de-risking dominated as a result. Emerging economies have moved mountains from a fiscal and monetary policy perspective in recent years, but higher domestic interest rates may be required to stabilize local currencies and could hamper growth and weigh on prices of stocks and bonds tied to developing nations over the near-term. For now, we would wait for the dust to settle as rising interest rates and macroeconomic forces could be temporarily punishing these bonds unfairly relative to fundamentals, potentially creating opportunities for active investors to find diamonds in the ruff.
As of November 13, 2024
