Investing
Can fixed income now deliver stock-like returns?
Investors might find income as well as some protection against a recession. Let’s explore where to look.
By any measure, this has been a tumultuous year for investing. (If your portfolio has been buffeted, you’re not alone.) Often in periods of market dislocations, risk-reward calculations shift, and certain potentially attractive investment opportunities may arise. The current environment might allow for equity-like returns in a fixed income portfolio with less risk than in an equity portfolio, given the typically less inherent volatility of the fixed income asset class.
In the first half of 2022 fixed income markets posted some of their worst returns in history. But despite severe market dislocations (and in a sense because of them), two factors could make it possible to achieve equity-like returns in fixed income: higher yields and wider credit spreads (the premium over the yield of a comparable Treasury bond). As a result, the asset class may now offer compelling income returns whatever the economic environment, as well as the potential for capital appreciation if the economy goes into a recession.
We look to combine three key components of the fixed income asset class:
- Core carry—Steady carry (income) with relatively low volatility, as currently found in municipal bonds and short-duration investment-grade corporate bonds
- Portfolio ballast—Protection against the risk-off market sentiment that typically accompanies a recession, now available in long-duration investment-grade credit and municipal bonds
- Higher income—Higher levels of income, currently on offer in preferred equity and other hybrid securities that combine characteristics of stocks and bonds1
A fixed income allocation anchored by core carry and including the other two components can potentially achieve equity-like returns with less volatility than stocks. That can be powerful combination.
Higher policy rates, higher yields
Today’s market dislocations partly reflect the fastest global rate-hiking cycle since the mid-1990s. It began in emerging market (EM) countries, as 12 EM central banks raised rates in 2021. The Bank of England also hiked rates last year.
Then in March 2022, the Federal Reserve (Fed) stepped in with its first hike this cycle, followed by three more hikes so far this year. The market anticipates that the Fed will keep hiking until the fed funds (policy) rate reaches around 3.5% by early 2023. (In mid-2023, investors are pricing rate cuts as the economy weakens.) As for the European Central Bank (ECB), in July it increased rates for the first time in 11 years.
As central banks have hiked rates and tightened monetary policy, yields across the fixed income landscape have risen substantially year-to-date. Today, investors can potentially achieve forward-looking returns in fixed income that are comparable to the total returns of the S&P 500 since 2000 (roughly 6.7% annually). And fixed income “instruments” will likely deliver those returns with less volatility than stocks.
The key to our positive view on fixed income assets is that we think U.S. Treasury (UST) yields are more likely to head lower than higher from here. We see approximately 3% as the upper end of the long-term fair value range, and expect 10-year USTs to trade below that level for most of a business cycle. In short, we’re probably closer to the end of the Fed’s tightening cycle than the beginning.
Wider spreads, recession protection
Spread levels also offer meaningful compensation for the possibility of debt defaults. The bond market is pricing in slower growth, although not yet fully pricing in a recession. As a result, credit spreads are wider than historical averages. Especially in the preferred and hybrid space, these spreads now offer protection against a significant economic downturn.
Focus on the three key components of fixed income
Amid these market crosscurrents, investors may explore using a mix of fixed income assets to seek equity-like expected returns while looking to minimize risk.
In the search for equity-like returns, investors can focus on three key components of fixed income:
1. Core carry—Municipal bonds and short-duration investment-grade corporate bonds offer the most attractive carry, or income. Their current yields are in the 4%–5% range1 with low volatility. Added to a portfolio, they can provide capital preservation and steady income returns. In our view, core carry holdings should make up the lion’s share of a fixed income allocation that looks to achieve equity-like returns with less volatility.
2. Ballast—Long-dated, U.S. investment-grade (IG) credit and municipal bonds offer portfolio protection against an economic downturn. That’s because they act as a hedge in a recession: As economic growth slows, central banks cut policy rates and the prices of long-dated bonds (Treasuries, IG and municipals) tend to rise. At the same time, the prices of risk assets such as stocks tend to fall.
Although the economy could still reach a soft landing, recessions odds have clearly risen in recent months. Long-dated municipals and IG bonds can thus provide a hedge to other asset classes in a risk-off environment that typically accompanies a recession.
OAS, Option-Adjusted Spread: The measurement of the spread of a fixed income security rate and the risk-free rate of return, which is then adjusted to take into account an embedded option.
3. Higher income—As spreads have widened dramatically this year, preferreds and hybrids now provide compelling yields of around 7%.
Unlike other types of extended credit (such as high yield), preferreds and hybrids are more likely to have negligible default rates. This reflects the fact that the underlying issuers are typically highly regulated investment-grade companies. That’s a benefit for investors.
On the other hand, investors may also take on meaningful interest rate risk in owning hybrids. That’s because hybrids are perpetual securities which are especially sensitive to changes in interest rates (as rates move lower, prices rise and vice versa). This seems to be a manageable risk, given our view that interest rates will likely move lower over the next 24 months.
Hybrids could also offer some capital appreciation potential, as markets assign a greater value to these securities’ relatively low default rates.
Although past performance is no guarantee of future results, in analyzing weekly data since 2012 for the preferred/hybrids market (the HIPS Index), these statistics are telling:
- When spreads are greater than 400 basis points (bps), median one-year forward excess returns have exceeded 20%.
- When spreads are greater than 300 bps, median one-year forward excess returns have exceeded 13%.
Given current spread levels of ~400 bps, this analysis indicates potential for equity-like performance in the preferred/hybrid space over the coming year.
Combining with core carry and portfolio ballast, the higher income of preferreds/hybrids can lead to a formidable fixed income allocation that delivers stock-like returns with far less volatility. Amid the churn of today’s dislocated markets, promising investment opportunities may be found.
We can help
In tumultuous markets, it is important to consider a wide array of investment options. Your J.P. Morgan team can help you evaluate what fixed income strategies may be considered to help you achieve your long-term goals.
Preferred equity is a type of equity that ranks senior in the capital structure to common equity, pays a fixed dividend (like a bond coupon) and does not mature (it is a perpetual security). A hybrid security is subordinated debt, senior to preferred equity in the capital structure, issued by utilities, telecoms and insurers, among others. Hybrids tend to have very long maturities (usually north of 60 years), with coupons that reset at defined periods. Both preferreds and hybrids are typically issued by investment-grade companies.
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