Carry Boosts Fixed Income Resilience in Likely Fed Scenarios

In Income Returns to Fixed Income Investing, we highlighted how the ongoing normalization of interest rates has made carry a meaningful component of return once again. This is enabling fixed income to be more resilient in the face of a wide range of potential market movements, including ones with even higher yields, credit spreads, or volatility. We believe that various fixed income asset classes are more attractive now and can serve as yield enhancers or portfolio diversifiers, or both, in a variety of market environments. In this blog we illustrate how three possible interest rate scenarios—Federal Reserve (Fed) pause, Fed pivot or hawkish surprise—may play out across different fixed income asset classes.

For each of the three scenarios, the table below lists estimated fixed income asset class returns over the next 12 months, as well as the yield levels these asset classes would have to exceed in one year in order for total returns to fall below 0%. Scenario 1 would suggest rates moving moderately higher and the Fed pausing in early 2023 amid continued market uncertainly and moderately wider credit spreads. Scenario 2 would suggest a Fed pivot and lower rates amid a moderate to deep recession (though not on the order of the Global Financial Crisis), with spreads settling at a level significantly higher than today. Scenario 3 would suggest the Fed is more aggressive than the market currently anticipates, in part because the economy remains robust, as reflected by tighter credit spreads.

As of 10/31/2022. 10 Year U.S. Treasury represented by ICE BofA Current 10-Year US Treasury Index; IG Corporates represented by ICE BofA US Corporate Index; HY Corporates represented by ICE BofA US High Yield Index; Fallen Angel HY Corporates represented by ICE US Fallen Angel High Yield 10% Constrained Index; EM HY Corporates represented by ICE BofA Diversified High Yield US Emerging Markets Corporate Plus Index; IG FRN represented by MVIS US Investment Grade Floating Rate Index; CLOs represented by J.P. Morgan CLO Index.

Using broad high yield as an example, at current levels the overall yield would need to increase by 2.29% to 11.35% to suffer a loss over the next year. That yield level has only been exceeded during four cycles in the last 25 years – the dot com bubble, the telecom blow-up, the GFC and COVID. The current yield level provides a substantial cushion to returns going forward, and as a result, high yield may provide positive returns even in a fairly dramatic spread widening environment. In fact, this is true for almost all of the asset classes listed above in almost all scenarios—although clearly some scenarios are more favorable than others. The key point is, however, that it is difficult to envision another year of returns similar to 2022, given the cushion provided by current yield levels and the significant rate and spread adjustments already experienced over the past several months.

All of the above analysis, of course, concerns nominal rates of return. Real interest rates and real returns in a static scenario, for the moment, remain negative for most bond asset classes. This is also why we believe it will take some time and a much harder turn in either the economic cycle or inflation before the Fed will be compelled to pivot. A deceleration and/or a pause is our default case over the next six months, but we do not see a high probability of both meaningfully lower yields and a soft landing in 2023.

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