27 Jun 2023
For the 12 years following the Great Financial Crisis, money market yields remained close to 0%, and bond yields were consequently repressed. It was hard to see their investment return value when bond yields were close to 2% to 5%. Many investors, therefore, treated bond positioning as a hedge, focusing only on high-quality/low-yield bonds that tend to rise in price when stock prices fall. However, today the entire bond spectrum exhibits different characteristics than when the Fed Funds Rate was 0%. Instead of low inflation, we have inflation higher for longer. We currently have an inverted yield curve, where short-term bonds offer higher yields than longer-dated bonds. Further, we have whole segments of the bond market offering yields in the 7%+ range. If bonds were used as a hedge during a low-rate environment, maybe during a high-yield environment, bonds are now a return opportunity? Capitalizing on this requires new thinking.
Most of us understand that the Fed Funds Rate increases have resulted in money market yields now approaching 5%. This has created an obvious income opportunity for savers. The reason that money market yields are 5% is that the Federal Reserve Bank is fighting inflation; to do that, they must match the Fed Funds Rate to at least the level of inflation. This is why money market yields usually offer about the same return as inflation, and long-term savers are not getting ahead in “real” or after-inflation terms. And then there are taxes to contend with. Often, investors need a way to enhance their income beyond the rate offered by money market funds or CDs.
If money market funds—the most basic financial instruments—currently yield 5%, imagine the income opportunities available in the capital markets. Due to several forces in the bond market, some bond mutual funds and ETFs currently offer yields over 7%.
Yield opportunities – Changing yields over the past two years
The rise in the Fed Funds Rate has clearly led to higher yields for money markets and short-term bonds. However, yield opportunities are more broadly diversified than that. Lesser-followed assets such as managed futures and bank loans also offer attractive yields tied to the Fed Funds Rate.
A second contributor to higher yields is the perceived credit risk of corporate bonds, specifically those bonds issued by BBB or lower credit-rated companies. These bonds, also known as high-yield bonds, often sell off when economic risks are ahead of us, like a potential recession. When investors sell bonds they perceive as risky, this lowers the prices and increases the yields of an entire sector of bonds. When selling these bonds, they often replace them with higher quality but lower-yielding bonds.
This gets us to the third aspect that is impacting bond yields. Many investors are likely still seeking hedge value in their bond exposure or owning bonds expected to appreciate if a recession occurs or stock prices fall. These investors have been hyper-focused on high-quality intermediate bonds. The hyper-focus on holding aggregate and intermediate high-quality bonds has resulted in a 10-year treasury yield of just 3.7%, or about half of the yield of lesser-held bonds.
Has all the juice been squeezed out of high-quality intermediate bonds? With intermediate-term treasury yields below the inflation rate and money markets yields, the path to the outperformance of these high-quality intermediate bonds is a very narrow window. It is hard to see how returns below 4% can outperform money market yields or even near-term inflation. The only scenario for outperformance would be a possible moderate to severe recession where inflation drops rapidly, and the Federal Reserve aggressively cuts interest rates. However, if you are seeking a return above money markets from your bonds, under most plausible scenarios, intermediate high-quality bonds appear impaired from that standpoint. Furthermore, what 2022 has taught us, in the face of inflation, high-quality intermediate bonds may not offer equity hedge value. Instead, they may fall in tandem with the prices of stocks.
A final and more nuanced aspect of the current bond market is what I call the short-term bond yield anomaly. Here is how this works. If most investors are focused on intermediate high-quality bond positioning, then, in turn, most of the assets in bond funds and ETFs, therefore, need to be intermediate in their duration. If an intermediate bond fund or ETF holds its bonds and doesn’t trade them, it quickly becomes a short-term bond fund. Held through time, all bonds become short-term bonds as they approach maturity. Simply put, if you hold a 7-year bond for four years, it becomes a 3-year bond. For intermediate bond funds and ETFs to remain intermediate, they must be constant sellers of short-term bonds. Thus, short-term bonds are constantly sold, depressing prices and raising yields. Weird huh?
This constant selling results in short-term bonds having higher yields than expected, especially considering short-term bonds’ lower-risk nature. This opportunity actually improves as more and more investors hold intermediate-term bonds. Further, add in the inverted yield curve where short-term bonds are the highest yielding duration, and we end up with an enhanced return opportunity in short-term bonds. This is why certain bond funds can capture 7% or more yield with a low-risk 2-year duration.
Frontier’s Conservative Income and Tax-Managed Conservative Income Strategies seek to capitalize on this opportunity. The current yield of the Strategies was 6.5% and 5.9%, respectively, as of May 31, 2023. Further, these strategies are risk managed, diversified across multiple asset classes, and dynamically managed to seek to achieve consistent return patterns. For further performance information, please download our Strategy Brochure.
Conservative Income – Income rate of portfolio holdings
The takeaway
While this time is not different, we believe the current bond market opportunities have changed. Investors are often slow to adjust to change, which we think may be the biggest portfolio positioning consideration for this market environment. The opportunity set of options the bond market currently offers is different from when the Fed Funds Rate was 0%. Again, if bonds were used as a hedge during a low-rate environment, then maybe during a high-yield environment, bonds have the potential for a return opportunity. Capitalizing on this potential opportunity requires new thinking and bond positioning that can adjust to this change in market dynamics.
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