The Fed’s inflation battle creates opportunities

This year has been tough for fixed income. The U.S. Federal Reserve’s aggressive assault on inflation and widening credit spreads have resulted in broad-based negative returns. On the upside, improved valuations offer an attractive entry point for patient investors. Higher yields have created opportunities for higher income, and therefore total returns, going forward. We continue to favor credit sectors, especially senior loans, high yield corporates and preferreds.

Key takeaways

• Bond yields have become much more compelling with a substantial increase in interest rates.
• Year-to-date losses create an attractive entry point for new money.
• Higher rates should benefit floating-rate products like loans, as well as shorter-duration markets, such as high yield credit and some emerging markets.

The Fed hiked rates twice in the second quarter — 50 basis points (bps) and 75 bps — to help fight soaring inflation. The total for the year stands at 150 bps, one of the sharpest increases in history. The shortest maturities were impacted most, as the fed funds rate is the shortest rate. The 2-year U.S. Treasury yield climbed +2.19% to 2.92% year-to-date, and the 10-year yield increased +1.46%, finishing at 2.98% (Figure 1). Rising rates impact bond prices negatively, so the returns of all fixed income sectors have suffered year-to-date. At the same time, risk increased and credit spreads widened due to rising inflation and the war in Ukraine with its resulting shock in energy prices. 

The market continues to predict a steady series of rate hikes this year. However, geopolitical concerns certainly cloud the outlooks for both growth and inflation. We anticipate another 75 bps hike at the July Fed meeting and a 50 bps hike in September, followed by 25 bps hikes at the final two meetings of this year. We expect 10-year Treasury yields to rise further, but do not see sharp moves beyond 3.0% to 3.5%.

A bad year for bonds

Due to rising rates and widening credit spreads, the broad bond market has declined -10.4% year-to-date (Figure 2). While it would be mathematically difficult to recoup such a loss during the current calendar year, it creates an attractive entry point for new money.

The shortest-duration senior loans and asset-backed securities fared best, and U.S. TIPS benefited from increasing inflation. Emerging markets debt suffered most, due to its longer duration profile and exposure to some of the regions hardest hit by the war.

Despite these losses, it is important to recognize that bonds generally have less negative returns than equities, which dipped -20% during the same period. Allocating a portion of a portfolio to bonds may help balance returns of other asset classes.

Rising yields make bond funds more attractive

Over the past several years, the income portion of fixed income has been noticeably absent. But bond yields have become much more compelling with a substantial increase in interest rates and the Fed hiking cycle well underway. The yield-to-worst on the broad bond market index has increased nearly 2.0% in 2022 (Figure 3).

Since more than 95% of bond market returns are driven by income rather than price appreciation,¹ these higher yields make fixed income investments a more compelling addition to portfolios. And bonds continue to anchor portfolios through their naturally low-to-negative correlation to equities,² helping build overall total return.

Consider actively managed core and multisector portfolios

While the yield on credit-oriented sectors appears very high, many investors may seek diversification during uncertain and volatile market environments. Using multisector portfolios, active managers have the ability to blend opportunities from the more conservative core sectors with smaller allocations of the higher return potential plus sectors.

Using deep fundamental research, active managers drill down into subsectors, industries and individual companies to uncover the fixed income instruments they believe can create the most value for investors.

To mitigate the negative impact of rising rates on principal:

Short-term bond funds. The lower duration profile reduces the impact of rates changes on portfolio returns while still benefiting from a wide array of sectors. These funds typically combine higher-quality, short-duration sectors — like U.S. Treasuries, asset-backed securities and mortgage-backed securities — with smaller amounts of higher yielding sectors, such as high yield corporates and emerging markets debt.

For higher income and return potential to help offset the negative impact of rising rates:

Multisector bond funds. The additional yield potential can help offset price declines due to rising rates. The funds augment a base of diversified higher-quality sectors with larger allocations (typically up to 50%) to below investment grade securities. This approach offers more yield potential than core plus, in return for greater potential volatility.

Core plus funds. The ability to actively adjust allocations to lower-quality segments may increase yield while balancing overall risk. These funds combine a larger portion of higher-quality sectors — like U.S. Treasuries, mortgage-backed securities and investment grade corporates — with smaller allocations (typically up to 30%) to lower-quality sectors, such as high yield corporates, senior loans and emerging markets debt.

Core/core impact with small amounts of plus sector exposure. These funds focus on higher-quality sectors to maintain return profiles similar to the broad bond market with a low correlation to equities. Core strategies with the flexibility to add small amounts (0% to 10%) of lower-quality sectors can be particularly attractive. Core strategies with an impact investing mandate add the diversification of responsible investing themes.

Outlook

No recession this year

Our outlook for economic growth has deteriorated somewhat. Monetary policy has been tighter-than-expected, and we see early signs of softening in interest-rate-sensitive sectors like housing. Though core price inflation has likely already peaked, headline inflation will likely remain higher for longer than we previously expected. This trend will weaken consumption and require even tighter monetary policy. We still do not expect a recession to start this year.

We anticipate the Fed will hike rates another 75 bps in July and 50 bps in September, then return to 25 bps increases at the final two meetings of this year. The European Central Bank will likely still raise rates later this year, though the overall level of rates in Europe will remain lower than in the U.S. In China, policymakers will likely pivot further toward economic support later this year.

Given the healthy near-term growth outlook, we continue to favor spread sectors and credit risk in asset allocation. We believe there is upside to long-end yields over the course of this year and anticipate the 10-year Treasury yield will finish between 3.0% and 3.5%. Higher rates should benefit floating-rate assets like loans, as well as shorter-duration markets like high yield credit and some emerging markets.