In August 2020, at the height of the COVID-19 pandemic, the 10-year U.S. Treasury yield hit a record low of 0.5%, boosting returns for fixed income investors. Indeed, the Bloomberg U.S. Aggregate Bond Index’s (Agg) total return was 7.5% for the year. In 2021, low starting bond yields begat low return expectations for fixed income investors. With a starting coupon of less than 3%, there was little interest income to support investors if rates rose and bond prices fell. At the same time, the Agg’s modified duration (i.e., interest rate sensitivity) reached a record high of 6.8 years. These two factors meant investors faced considerable downside return potential if interest rates rose, which is exactly what happened.
Rates rose materially over the ensuing 24 months, leading to a decline in the Agg of 1.5% in 2021 and a previously unthinkable loss of 13% for the index in 2022 – the largest calendar-year decline in its history. With inflation concerns mounting in 2022, the Federal Reserve (Fed) went into attack mode, raising its overnight Federal Funds target from zero to a range of 4.25% to 4.5% by the end of the year. By October 2023, the 10-year Treasury reached a 16-year high of 5%. As inflation pressures subsided, bond and stock markets began anticipating a Fed “pause to pivot” in 2024. This drove a late-year rally for the Agg, which gained 4.5% in November and 3.8% in December. Losses for a third consecutive year were avoided and the Index ended 2023 up a solid 5.5%.
The Fed’s actions appeared to bring inflation under control and achieve a soft economic landing in 2024. This balancing act led to a slight rise in the Agg (up 1.3%) for the calendar-year while the S&P 500 gained 25%. Shown below, the performance disparity between stocks and bonds has been extraordinarily one-sided in favor of stocks over trailing 1-year, 3-year, 5-year, and 10-year periods. Investors have justifiably begun to question why they should bother with fixed income.
Source(s): Factset; Bloomberg; As of 12/31/24
After ten years of strong performance, an enthusiastic stock bull might anticipate further gains. However, even the most optimistic equity investor might concede that at least a pullback of stock performance in favor of bonds is overdue. The Fed model,2 which compares the S&P 500's earnings yield to the 10-year U.S. Treasury yield, has turned cautious for stock investors after a decade in their favor. Heading into 2025, the model shows no clear preference for either asset class, suggesting that investors should hold the line for now and be prepared to rebalance down the road.
Data sources: Robert Shiller, Standard & Poor’s and Bloomberg LP, 1962-2024; As of 12/31/2024
Reviewing the Agg’s key components—price, coupon, and yield—highlights its potential for price improvement in addition to income. It should help investors understand why they should still bother with fixed income in 2025. At the end of 2024, the index price was ~$90 (par $100), with a 3.4% coupon and a 4.9% yield to maturity. Until the interest rate cycle reversed in 2021 and 2022, it consistently traded at a premium, with an average price of $102, due primarily to the lingering deflationary environment post-1980s. The current price implies the opportunity to purchase a core fixed income portfolio at a meaningful discount to par.
The traditional role of fixed income, which protects portfolios in down (or deflationary) equity markets, is believed to be back in play based on the current construction of the Agg. Looking back to prior periods of market disruption, such as 2008, shows the value of maintaining an allocation to traditional fixed income. While the S&P 500 lost 37% that year, the Agg played its traditional role with aplomb, gaining 5.2% and thus dampening equity declines. Even the Agg’s 2022 loss of 13% was still better than that of the S&P 500, which dropped 18.1%. Granted, this was a small comfort to many investors. Still, the Agg’s inability to play its traditional role in 2022 was a unique byproduct of a low starting yield and a rapidly emerging inflationary environment.
While the Agg offers decent carry in the form of interest income, spreads on publicly traded bank loans and high-yield bonds have tightened similarly to investment grade (IG) corporates, which is consistent with late-cycle environments. We are cognizant of the potential for credit spreads to widen quickly in the event of a downturn and are waiting for a more attractive opportunity to allocate to this space.
Private credit has continued to garner interest among investors and on Wall Street in recent years as a potential source of additional carry. Some unlevered lending-oriented strategies can create an illiquidity premium above bank loans and high-yield bonds of 200 to 400 basis points, which could be higher using more exotic approaches. To the extent investment guidelines allow, FEG favors these strategies to build broadly diversified fixed income portfolios meant for all-weather protection.
Contact us to learn more about how private credit can complement Agg-based bond strategies to enhance portfolio yield while preserving important diversification benefits.
1-2The Fed model is a valuation methodology that measures the relationship between the 12-month forward earnings yield of the S&P 500 Index versus the yield to maturity (YTM) of the 10-year Treasury bond.
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Index performance results do not represent any managed portfolio returns. An investor cannot invest directly in a presented index, as an investment vehicle replicating an index would be required. An index does not charge management fees or brokerage expenses, and no such fees or expenses were deducted from the performance shown.
The S&P 500 Index is a capitalization-weighted index of 500 stocks. The S&P 500 Index is designed to measure the performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.
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