Investment-grade credit is now yielding close to 5%, on average.
Dreamstime
After a devastating six months for both stocks and bonds, strategists are warrming up to fixed-income investments even as they remain skittish about equities. It is increasingly possible to generate decent income in the bond market without taking on too much risk.
So far this year, the Bloomberg Barclays U.S. Aggregate bond index has fallen almost 11% as the Federal Reserve has ramped up its fight to control inflation with higher interest rates. A net $170 billion poured out of bond funds from the start of the year through the end of May, according to Morningstar Direct.
“Investors have been stung by the bond market and the natural reaction is to get away,” says Warren Pierson, co-chief investment officer at Baird Advisors. “After the shock of the sting wears off, people will be amazed they can get 4% in a short-term investment-grade bond fund, compared with 1%” at the beginning of the year.”
Those higher yields are becoming alluring—especially because the income now offers a bigger offset than it did late in 2021 against losses from declines in bond prices. Investment-grade credit, for example, is yielding close to 5%,on average. Even ultrashort funds, often seen as an alternative to cash, offer more than 3.2%, compared with 0.69% at the beginning of the year.
The medium-term outlook is also better. For years, bonds had been left for dead as the Federal Reserve kept interest rates near zero, leaving investors to look for income from stocks. Now, the Fed’s hikes are pushing rates higher, giving the central bank room to cut them again if it needs to.
“If you have a cooling in the economy and, meanwhile, rates have risen to take account of inflation, eventually the Fed can cut rates but it doesn’t have to jump in and flood the market with cash,” as it it did during the pandemic with quantitative easing that drove yields lower, says Sonal Desai, chief investment officer of Franklin Templeton Fixed Income. “That improves substantially the outlook for bonds.”
Stocks, meanwhile, are vulnerable to more losses as investors adjust to the likelihood that slower economic growth will hurt corporate earnings. Growth in profits could be 10% to 30% lower than it otherwise would have been, depending on how much the economy weakens, according to Erik Knutzen, who heads Neuberger Berman’s asset-allocation committee. The firm remains positioned to ride out more market weakness, overweight cash and underweight stocks.
Knutzen’s team is turning more positive on bonds as yields on high-yield debt, for example, hit 8.5%, offering an attractive alternative to equities at a time strategists are bracing for lower near-term returns from the stock market.
Michael Contopoulos, director of fixed income at Richard Bernstein Advisors, also is warming to bonds. Contopoulos writes that while yields on the 10-year may not have hit their apex, leaving the possibility of modest further declines in bond prices in the near term, they are closer to that point than in the past two years.
Yields on 10-year Treasury debt would have to rise to 4.3% over the next two years for anyone who brought a 10-year Treasury note last week to realize a loss, Contopoulos says. Yet if the economy enters a recession in the next two years, and yields fall to 1.5%, those notes could return 17% to 23%, he says.
If the smart money is looking toward bonds, what should investors buy? The first place to look, according to Desai, is better quality, investment-grade bonds and U.S. Treasuries—the asset classes where pensions and others with long-term liabilities are likely to put money as rates rise.
Contopoulos has added recently to his firm’s holdings of floating-rate investment-grade corporate bonds and AAA-rated collateralized loan obligations. Many strategists and money managers favor shorter-term securities, reasoning that the shorter the duration, the quicker investors will be paid back, reducing the risk of further increases in interest rates or a widening of the gap in yields between that debt and Treasuries—-two factors that would mean lower prices.
As a result, Knutzen has been looking for opportunities in short-duration credit and short- and intermediate-term investment-grade bonds, as well as mortgage-backed securities.
Within investment-grade credit, Baird Advisors’ co-chief investment officer Mary Ellen Stanek favors debt from financial companies. Banks have to maintain their investment-grade ratings, tend to issue more intermediate-term debt, and are in very good shape in terms of capital ratios after the regulatory changes that followed the 2008-2009 global financial crisis, she says.
Also attractive are parts of the municipal bond market, which offer tax-adjusted yields of as much as 7.5% to 8% for investors in high-tax states like New York and California, Stanek says.
Many money managers also see an emerging opportunity in high-yield credit. Baird’s managers are beginning to buy, noting that corporate balance sheets are still largely healthy, reducing the risk of defaults, although Stanek says the team is moving slowly because better opportunities could still be ahead.
David Rosenberg, founder of Rosenberg Research, is less confident. He says credit investors appear complacent about the likelihood that companies won’t be able to handle their debts. If yields on corporate debt rose to 7 percentage points above Treasuries, compared with 5 points recently, he would feel better about the outlook, Rosenberg said.
The bottom line is that bonds are no slam dunk. Uncertainty over whether the U.S. will slip into a recession, how deep it would be, and whether the Fed will succeed in getting inflation under control argues for selectivity in snapping up debt. Yet yields have improved enough to offer a buffer against the additional losses in areas such as stocks that likely would come if the economy begins to shrink.
