Income Returns to Fixed Income Investing

Coming into 2022, all financial asset prices factored in an enormous amount of excess liquidity provided by the world’s largest central banks. Meanwhile a persistent inflation problem was about to erase the notion that the banks would not be willing to take that liquidity away if it meant upsetting markets. Now, central banks are indeed removing it, and from a long-term perspective around the health of the global economy, we should hope they continue to remove excessive accommodation. But in 2022, so many asset classes that were highly correlated on the way up are remaining highly correlated on the way down.

Making the problem more acute for income investors, who a couple of decades ago could rely on reasonable current income to mitigate price losses when yields were rising, there was very little “carry” in traditional bond portfolios at the start of this bear market. One silver lining is that now there is. Another positive is that the price of incremental risk in some fixed income markets has de-compressed. More specifically, carry has increased by greater magnitude the farther out the credit risk curve one goes.

Put another way, current income is now playing a very significant role in bond returns. At the start of this year, when 10-year Treasuries (represented by ICE BofA Current 10-Year US Treasury Index) carried a yield of 1.50% (as of 12/31/2021), not only was the interest income negligible, it was only enough to absorb a 0.16% rise in yield over the next 12 months before an investor was underwater on a total return basis. Even high yield corporate bonds (represented by ICE BofA US High Yield Index), which were yielding on average 4.35% in January, only provided enough yield to make up for a combined 1.04% rise in the risk-free rate and credit spread over the next 12 months. Needless to say, the rises in yields and spreads over the past 12 months have been higher by several orders of magnitude, and losses have therefore been severe. The 10-year yield has risen 239 bps to 3.89%, and investors have lost 17.4% including interest; high yield corporates rose 492 bps to yield 9.27% on average, and investors have lost 13.3% including interest, as of 10/7/2022.

Currently, however, carry affords fixed income investors a much larger cushion. The income earned on the current 10-year Treasury note provides a return buffer that would allow investors to break even, even if the yield increases by 48 bps to 4.37% over the next year. For high yield investors, the carry is high even by historical standards. The yield at which investors would break even in 12-months’ time is about 11.59%, or 232 basis points above where it stands today.

Higher Carry Provides Greater Cushion Against Higher Wider Yields

As of 10/7/2022. 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 lHigh 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. Past performance is no guarantee of future results.

The great news for bond investors is that interest rate normalization has returned us to a world where carry is a meaningful component of return, where duration, credit and liquidity risk are priced more appropriately, and where a far greater range of scenarios can lead to positive returns. Importantly, we also believe the role of fixed income in diversified portfolios will be as important as ever as correlations also return to normal in the absence of quantitative easing.

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