With peak interest rates likely within view, now could be a time to consider bolstering portfolio yields for the longer term.
For years, the calculus for fixed income investing was a challenging one. After the Global Financial Crisis, central banks kept interest rates at exceptionally low levels to reinforce economic stability, with the effect of spring-loading a long-term bull market in equities and other “risky” assets, while leaving many bonds with minimal income streams to attract investors. With inflation well under control, there was little incentive for central banks to raise rates back to more normal historical levels. However, as the world learned in the wake of the COVID pandemic, inflation was not a thing of the past, as resurgent prices forced the historic spike in interest rates that sent stocks tumbling in 2022 and bond indices to their worst annual performance in modern memory.
The issue that bonds might not fulfill their historic function as a portfolio ballast was one that we previously discussed, pointing to the benefits of diversification beyond traditional assets. Unfortunately, this forewarning didn’t necessarily offset the pain of those who experienced the one-two punch of declines in their stock and bond holdings. That said, time has a tendency to heal market wounds—equities are up substantially this year, but more importantly from a portfolio construction standpoint, the reset in bond prices has reintroduced yield back into fixed income markets. Regardless of one’s views on the recent stock market rally, we see renewed opportunity within fixed income to provide balance to portfolios. Gains in equities could set the stage to adjust strategic portfolio weightings more toward fixed income, on a tax-sensitive basis, in order to fulfill both income and total return goals.
Income Is Back
Current Yield by Fixed Income Segment
Source: Neuberger Berman, Bloomberg, as of June 30, 2023. Municipals are represented by the Bloomberg Municipal Bond Index, U.S. Treasury by the Bloomberg U.S. Treasury Index, Securitized by the Bloomberg U.S. Securitized: MBS/ABS/CMBS and Covered Index, U.S. Investment Grade (IG) Corp by the Bloomberg U.S. Corporate Bond Index, Emerging Markets (EM) Hard Currency by the Bloomberg Emerging Markets Hard Currency Aggregate Index, U.S. High Yield by the Bloomberg U.S. Corporate High Yield Bond Index. Nothing herein constitutes a prediction or projection of future events or future market behavior. Municipal yields are on a tax-equivalent basis, assuming a marginal tax rate of 37% and Affordable Care Act investment tax of 3.8%, for a total of 40.8%.
Last Mile for Tightening
Significantly for the prospects of bond markets, the Federal Reserve has made meaningful progress in curbing U.S. inflation, which has fallen from a peak of over 9% last year to 3% in June.1 It’s true that the tone of the Fed and other central banks recently took a more hawkish turn, with several continuing to increase rates given the slow pace of recent price deceleration. And although the Fed paused at its most recent meeting, it signaled that additional small increases might be possible this year. That said, we believe the residual effects of tightening, including softer lending on the part of banks, have yet to be fully reflected in inflation levels, which we see continuing to recede in 2023 before nearing the Fed’s target of 2% by the end of 2024. All told, although market interest rates could inch up from here, we believe the tightening cycle is likely close to an end. What comes next could be a period of high but stable interest rates, followed by declines in those rates due to inflationary softening.
From an investment perspective, we believe this has two somewhat conflicting implications. First, there remains some time to capitalize on elevated short-term interest rates through shorter-maturity bonds and cash. Second, and in contrast, it may now be worth considering a gradual move toward longer maturities. Given the pending end to tightening, the risk of longer bonds associated with higher rates appears relatively modest, and looking out a year or two, prospects for capital appreciation from current levels seem favorable. Importantly, yields provided at the long end of the curve, although now typically lower than cash rates, may look far more appealing once the process of monetary easing begins. Indeed, those investors who remain short for too long may find that their reinvestment risk (finding securities at yields at or above current levels) has grown.
While bearing in mind this duration issue, we believe that fixed income merits a new look from investors, across a range of sectors:
Municipal bonds naturally take center stage for many individual investors in light of their tax advantages for those in higher tax brackets. The tax-equivalent yield for the Bloomberg Municipal Bond Index was recently about 6%,2 better than for many fixed income asset classes. Given potential economic softening, the quality of municipals also stands out, as tax-base deterioration tends to lag impacts on the broader economy. (That said, state governments can be more cyclically sensitive, pointing to the need for close attention from portfolio managers and credit research analysts on issuer health.) Current uncertainty also enhances the opportunity for differentiation based on fundamentally driven research and trading—key benefits of actively managed strategies. More tactically, investment outflows that affected the market in 2022 appear to have stabilized, while municipal supply has been modest and, in our view, should be met with ample demand as investors are attracted by higher rates and tax efficiency.
Investment grade corporates and other taxable bonds may also provide a compelling combination of moderate risk and higher yields relative to norms since the Global Financial Crisis. In our view, tighter monetary policy and growing weakness in the economy merit an emphasis on quality and security selection, as fundamental differences among issuers becomes more apparent. That said, income potential associated with select high yield exposure may be appropriate for some investors, especially given still relatively muted default expectations into next year. Although the yield advantage (or spread) from high yield has tightened somewhat recently, a likely growing dispersion in individual performance should provide opportunities in the coming months.
Emerging Markets Debt
Emerging markets experienced a difficult 2022 in the face of higher U.S. interest rates and economic disruptions tied to the Ukraine conflict. At this point, however, we believe the picture has brightened considerably, supported by attractive valuations and stable fundamentals, coupled with the coming end to aggressive U.S. rate increases, which tend to affect emerging markets debt pricing. Importantly, the process of disinflation is now accelerating in most emerging economies, with easing cycles emerging following long monetary pauses at elevated interest rate levels. Questions remain around China’s stalled economic recovery, but we believe impacts across emerging markets, if uneven, should ultimately prove benign.
Beyond the public markets, a thriving universe of private lending is generating meaningful opportunity for return and income generation. The market for private credit has exploded in size, diversity and complexity since the days of the Global Financial Crisis, filling a gap left by banks that abandoned or reduced exposure to debt from many private clients. Private credit markets continue to expand in size, choice and sophistication. We believe that, where suitable, they can play an important role in well-diversified investment portfolios.
The Big Picture
In general, we believe exposure to fixed income is not an “either/or” proposition but rather a function of risk and return potential combined with the specific goals for a given portfolio. As such, with our observations we are not advocating any radical change in allocations or strategy. That said, we do believe that ongoing shifts in market dynamics and risk/return ratios merit reassessment of portfolios, particularly given uncertainties as to the near-term trajectory of the economy and markets generally. Working with your NB Private Wealth team, you can help clarify these issues and assure that your portfolio falls in line with your risk profile and your goals for your investments.
1 Core inflation (excluding food and energy) was 4.8%. Figures are year-over-year.
2 As of June 30, 2023. Assumes a federal tax bracket of 37% and Affordable Care Act investment tax of 3.8%.
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