Fixed Income: The Case Against Piling Into Cash

During the past several years, investors poured money into fixed income mutual fund and ETF holdings — to the tune of roughly $2 billion per week in the municipal space and the neighborhood of $5 billion in the taxable space. The surge in demand drove yields on municipal bonds to less than 0.9 percent (based on the Bloomberg Barclays Municipal Bond index), while taxable bonds (based on the Bloomberg Barclays U.S. Aggregate Bond index) saw yields drop to less than 1 percent in 2020 before recovering modestly to yield around 1.5 percent throughout much of 2021 — and yet the dollars kept flowing.

Oh, how the world has changed. The Federal Reserve began raising rates in early 2022, and many fixed income investors began selling on fears that interest rates would keep climbing and reduce the value of their current holdings. But despite the dramatic uptick in yields, with the Bloomberg Barclays Municipal Bonds index near 3.75 percent and the Aggregate index around 5 percent, the outflows from intermediate bonds funds continues.

Improved yields for high-quality fixed income

No doubt the rush out of bonds was spurred by the correction that has swept through both equities and fixed income this year. However, it is important to remember that significant drawdowns in markets can lead to meaningful improvements in the risk/reward profiles of an asset class. In the case of high-quality fixed income (think Treasurys, agencies, municipals as well as investment-grade corporate bonds), this creates an opportunity to “lock in” yields that earlier this year were available only from junk bonds. The upshot is fixed income investors are now earning greater yields on high-quality bonds.

Fortunately, cash flow from high-quality fixed income is less likely to be impaired or suffer a default than junk bonds or even dividend-paying equities. The structural differences between bonds and stocks makes “buying the dip” in bonds much more certain from an expected return perspective. Consider that if a high-quality bond yielding 2 percent at par ($100) declines in value to approximately $87, it will then yield 5 percent; that is the yield a buyer (or holder from that point forward) can expect to earn to maturity. There is typically very little risk that the cash flow itself will be impaired. This is in stark contrast to equities, for which earnings can decline or turn negative and dividends can be cut or suspended; or high-yield bonds, where issuers can default, impairing future cash flows including principal.

Currently, the Treasury yield curve is inverted, meaning yields on short-term bonds (those that are issued with a six-month to two-year maturity date) are higher than those that won’t mature for five to 10 years. As a result, some investors are opting to hide out in cash or short-term bonds as they wait for the dust to settle on the current rate tightening cycle. With short-term Treasurys offering a return competitive with longer-duration bonds, it’s reasonable to ask, “Why take on the risk of rates rising further?”

Consider your time frame

It’s probably safe to say that most investors have a horizon that is longer than six months or a year. With respect to fixed income, you can buy bonds one cash flow at a time in the form of a six-month bill (or one-year bill) or as a package of cash flows, such as a five-year or 10-year bond. But as the markets have reminded us this year, nothing is certain. While yields on a six-month or one-year Treasury may be higher than a five-year or 10-year bond right now, there is no guarantee that they will remain that way. As a result, when it is time to reinvest the proceeds from the bonds in six or 12 months, it is possible that short-term rates may drop back down below the yields offered by longer-term debt. This uncertainty is known as reinvestment risk. This is likely to happen if the Fed is successful in taming inflation further over the next few months and the economy slips into recession. An inverted Treasury curve implies that interest rates will be lower in the future; in essence, the market indicates that when it is time to reinvest a short-term bond, rates are expected to be lower than where they are today. Conversely, buying a longer-term bond now allows you to earn a higher rate for longer, even if that current yield is slightly below a short-term rate (as is the case in the Treasury market today).

A closer look at valuation

A lot has changed this year in fixed income from a valuation standpoint. If you look at the amount of interest income investors can earn per unit of risk compared to last year, it’s eye opening. The so-called “Sherman ratio” is a simple way to measure the amount of return relative to risk in the fixed income space. Looking at the Bloomberg Barclays Intermediate Aggregate Index, as recently as October 2022 investors were receiving roughly 108 basis points (1.08 percent) in interest income per unit of duration. Duration is a measure of interest rate risk or sensitivity. The current Sherman ratio translates to a return/risk ratio that is more than 4.5 times the 0.23 percent an investor received per unit of risk at the beginning of 2021.

From 2009 until this year, the yield on investment-grade corporate bonds was less than the earnings yield of the S&P 500 (at some points, more than 300 basis points less). This reality gave rise to a TINA (“There Is No Alternative”) mindset when it came to equities. In other words, yields were so low in fixed income that they failed to offer a compelling alternative to equities. However, the rapid rise in interest yields this year has resulted in high-quality fixed income offering investors a reasonable alternative. As of the end of October, yield on the Bloomberg Barclays Corporate Bond was hovering near 6 percent — higher than the earnings yield of the S&P 500, which is below 5.5 percent at a time when those earnings may come under pressure should the economy dip into recession.

Some historical perspective

Although it is reasonable to feel a bit shell-shocked this year after the historic decline in the fixed income market, it’s important to put risk in perspective. Since 1926, stocks have posted negative returns 25 times on an annual basis. In all but four of those instances (as well as year to date in 2022), the bond market recorded positive returns. The years in which fixed income had negative returns were 1931, 1946, 1969 and 1973.

The key takeaway is that the performance of bonds this year in relation to negative returns in equities is very unusual and, based on history, unlikely to persist. The common thread among three of the four outliers (1931 being the exception) as well as what has occurred this year is that they coincided with periods of elevated inflation of 5 percent or more, a level we do not believe will be repeated in 2023 and beyond.

The value of diversification

Although it is tempting to pile into short-term Treasurys when the Fed is aggressively raising rates, it may make more sense to take a more diversified approach and allocate at least a portion of your fixed income exposure to intermediate- or longer-term bonds, which will allow you to lock in higher rates for a longer period of time. Mortgages can offer an example from everyday life. As a borrower, you are looking to lock in the lowest rate you can on your mortgage for as long as you can. However, as a bond investor, you are taking the role of a mortgage company, meaning you want to lock in higher rates for longer. The higher yields offered in the fixed income markets today on intermediate- and long-term bonds offer just such an opportunity. Holding these instruments could help you avoid reinvestment risk should the economy weaken and rates retreat from current levels.

As always, if you’re concerned about how recent volatility in the bond market could impact your financial plan, you should have a conversation with your advisor. However, it’s important to remember that high-quality fixed income is an important source of diversification that can protect investors during a recession. While the recent pullback was unusual, a comprehensive financial plan is constructed to account for the unexpected.

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