Tuesday, November 7, 2023
After over a decade of very low interest rates, the rapid rise in rates recently has been the primary reason most fixed income asset classes have generated negative returns. And while the losses for some asset classes have been steep (and historically awful), we think the risk/reward for fixed income has improved and think the probability of further losses has decreased. Why? Higher starting yields.
While not unique to fixed income per se, the asset class has a feature that makes negative price performance increasingly difficult to continue due to rising rates alone. Fixed income returns are a combination of price performance and income so as yields rise, the income component increases as well. The higher income component serves as a “hurdle rate”, or a yield cushion, that will need to be eclipsed before further losses are realized. As such, these higher hurdle rates may decrease the probability of losses due to an increase in interest rates.
Currently, the highest hurdle rates reside in the short-to-intermediate categories but have improved in most sectors. For example, in order for the short Treasury category (1-5 year Treasury securities) to generate a loss over the next 12 months, interest rates would need to increase by more than 2.56% from current levels. Similarly, given the increase in yields for the intermediate corporate credit category, interest rates would need to increase by 1.5% from current levels to offset current levels of income. However, while hurdle rates are the highest for shorter maturity sectors, the increase in yield cushion for (most) longer maturity sectors has improved as well. Taking on some duration risk makes more sense now than it did a few years ago. That said, it would only take a 0.33% increase in yields to offset current levels of income for the long Treasury category—something that is within a likely distribution of outcomes. And while we can’t rule out the possibility of still higher rates at this point, we think it would take a steep resurgence in inflationary pressures to get to the levels needed to generate further losses on most fixed income asset classes.
The move higher in yields recently has been unrelenting but we think we’re closer to the end of this sell-off than the beginning. Over the past decade, interest rates were at very low levels by historical standards. Now, the recent sell-off has taken us back to longer term averages. That is, at current levels, yields are back to within normal ranges. And while the transition out of the low interest rate environment to this more normal range has been a challenging one for fixed income investors, we think, given higher starting yield levels, the chances of further negative returns over the next year have declined.
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