Riding the Curve: Isolating Income

George Bory: So, the Fed’s (Federal Reserve) one-prong strategy quickly became two-prong and may ultimately become three-pronged. So, what does this do for fixed income investors? Well, we think we’re actually in a pretty good environment.

Henri Proutt: That’s George Bory, chief fixed income strategist for Allspring Global Investments. And I’m Henri Proutt, portfolio specialist for the Global Liquidity Solutions team here at Allspring, and you’re listening to On the Trading Desk®. Today, we’re discussing the topics of riding the curve and isolating income across the fixed income landscape. Thanks for being here, George.

George: Thanks for having me on the show, Henri.

Henri: Let’s start, George, with some recent events. On March 22, the Federal Reserve raised the funds rate by another 25 basis points despite the broad market volatility from earlier in the month. Can you provide the listeners our perspective on how markets will process any additional rate hikes with the potential for a recessionary environment ahead?

George: Yeah, sure. That’s a great point, Henri. And as most of our listeners know, the Fed’s been in inflation fighting mode now for about 15 months, as inflation surged both during and after the pandemic. And it’s taken a while, but the real economy started to show signs of the impact of tighter monetary policy earlier this year, as both kind of growth sort of showed some signs of slowing and really, more importantly, the banking sector came under considerable pressure late last month. And a few banks even defaulted, as well as we’re seeing kind of softness in real estate prices more broadly. Now, all that’s occurred, as inflation has come down, but still remains elevated. So, the inflation fight, it’s not over. But the Fed is trying to fight now a two-pronged battle. First is it needs to contain inflation and that’s been very well established. But they also need to maintain order in the financial system. And tackling these two challenges at the same time has many, many challenges that go along with it. Now, admittedly, there is some signs of success, as I pointed to, as I mentioned, inflation is coming down and there is some restored sense of stability in the financial system. But it’s not over yet. So, we expect the Fed to stick with its plan to contain inflation and while they do so, they’re going to let growth slow and possibly even contract. And so, when we think about kind of the market and what the Fed’s doing, we expect the economy to show further signs of slowdown in the coming months. And this includes a weaker job market, slower consumer spending, and eventually a contraction in growth, at least in real terms. But I say real because nominally, the economy is still expanding. Now a lot of that’s due to inflation, but it creates sort of an interesting dynamic where we have effectively kind of a two-speed measure and that two-speed measures should on balance be net positive for bondholders, as inflation comes under control but is going to represent and present both opportunities, as well as challenges as we try to balance this difference between real growth and nominal growth.

Henri: And that leads us into our next question quite nicely. We published a paper titled, Isolating Income, talking through how yields have changed over recent months. Why should investors be paying attention to these changes for income potential available in public fixed income today?

George: The big difference between 2022 and 2023 for bond investors can be summed up in one word and that is income. At the start of 2022, there simply wasn’t any income available in the bond markets or you had to search very hard or take considerable risk to generate even modest amounts of income. But when we look at the markets today, after a year of revaluation, there’s a wide range of income opportunities across the entire fixed income landscape. At all points along the curve up and down the rating spectrum in both real and nominal terms, we can safely say or confidently say that bonds generate attractive amounts of income. So, in short, when we hear about it in the press and when we say bonds are back, that’s absolutely true, but we’d also emphasize that they’re back because of these income generating characteristics. And when we sort of put that into context, bond yields broadly sort of generate income anywhere from say 4% up to as high as 10% and in some cases, even higher. And that’s just in the publicly traded bond markets. And these are levels we’ve not seen in well over a decade. So, the value proposition is attractive. But more importantly, it allows bonds to do what they’re supposed to do in a portfolio, in an investment portfolio, and that’s three things. One is generate income. Number two is it provides a buffer against future volatility. And then number three, it provides diversification against cyclical risks. And today, bonds in the bond market, all three of these factors can be harvested and used and all three of which should translate into attractive risk-adjusted returns over the coming months, quarters, and even years.

Henri: What can you expand upon the need for income to support returns in fixed income portfolios now that we have higher yields and an inverted yield curve?

George: Yeah, Henri, that’s a great point. It’s easy to say income, income, income. But how does that work? Well, income dominates the returns in a fixed income portfolio. In fact, well over 90% of the return of a portfolio made up of bonds will simply come from the income received on those bonds and the reinvestment of that income. And so, the higher the rate, the higher the return, assuming you’re able to realize that as you move through time. And so, it’s this simple observation that underscores the importance of isolating income in fixed income portfolios. And this is to ensure that that fixed income portfolio compounds at the highest rate possible over time. Now, as I mentioned before, the Fed’s still in tightening mode and they’re likely to keep rates tight for an extended period of time, as they try to contain inflation. Now, this should work to the benefit of bondholders, as we move through time, as inflation comes down and bond yields ultimately decline. But in the short term, it likely keeps the yield curve inverted and encourages investors to harbor significant allocations at the front end of the curve to try and maximize income and limit risk. Now, when we look at our portfolios, we look at our strategies, we broadly agree with this. We want as much income as possible. It tends to be at the front end of the curve. But when we think about what’s happening, sort of from a macro perspective, it also suggests now is the time to start extending duration to ensure that today’s yield and income is locked into your portfolio for an extended period of time. These rates at the front end aren’t going to be here forever. Eventually, the Fed and other central banks will start to normalize policy, at which point it will just simply be too late to extend duration. So, when we look across regions, we look across markets and maturities, bond yields are, as I mentioned before, anywhere from 200 to 500 basis points higher over the last 18 months. And it’s at these current levels where fixed income investors stand a very good chance of beating inflation, not only over the next six months, but if you lock in rates further out the curve, you can extend and actually beat inflation, say, for over the next 5 to 10 years. You can also offset at least a large percentage, if not all the losses, from credit erosion over that particular time period. And so, capturing this yield and compounding it through time really should be the objective of every single fixed income investor.

Henri: So, with that all being said, regarding income and extending duration and just to wrap up our conversation today, can you provide some perspective to listeners regarding how Allspring’s fixed income teams are riding the curve in this environment?

George: Yes, absolutely. Well, to say that environments fluid is an understatement. As I mentioned before, we’ve got very high inflation. We’ve got a banking system that’s showing signs of weakness. And now we’re starting to see growth show signs of slowing, as well. So, the Fed’s one-pronged strategy quickly became two-pronged and may ultimately become three-pronged. So, what does this do for fixed income investors? Well, we think we’re actually in a pretty good environment. Policymakers, led by the Fed and other central banks around the world, are trying to contain inflation. That ultimately works to the benefit of bondholders. So, we look at our portfolios and we effectively have a three-pronged approach. Number one, as we mentioned, isolate income and harvest as much as possible. From our perspective, short duration, high income strategies still make sense in this environment. If you’re able to go down the rating spectrum and add some high yield securities into your portfolio, even the highest quality, high yield securities still yield well north of 7% and represent good value and should be able to weather upcoming economic weakness, as well as volatility in the rate markets and still provide a low likelihood of realized volatility in the portfolio going forward. Number two, as I mentioned before, start to extend duration. These yields aren’t going to be around forever and this tighter monetary policy that’s been implemented over the last 15 months and is still being implemented today, it will affect the real economy. Growth should slow and, again, that will work to the benefit of bondholders. And you want to have a longer duration position in the portfolio to benefit from that. And the third and perhaps most important is preserve liquidity. As I mentioned, there are a lot of meaningful moving factors in today’s market. Being able to sort of pivot your portfolio quickly and efficiently is critically important. It doesn’t matter if you’re in money markets, short duration, intermediate parts of the curve, or at the long end. Being able to sort of move up and down the curve dynamically and rotate through sectors and pick individual securities that matter is ultimately what’s going to drive the final performance in your portfolio. Being on the front foot, taking an active position in portfolio management, in our view, is the best way to achieve those objectives. So, isolate income, extend duration, stay liquid. Those three strategies should serve you well this year and over the coming years.

Henri: George, thanks for being here today and sharing your insights.

George: Thanks a lot, Henri. Great show.

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Disclosure: 100 basis points equals 1.00%. Diversification does not ensure or guarantee better performance and cannot eliminate the risk of investment losses.