Q. Why not stick to six-month Treasury bills at 5.1%?
A. Treasury bills present a near-term liquidity strategy solution but their yields exhibit high variability over longer cycles due to their correlation to the fed funds rate. This means that investors face reinvestment risk when the instrument comes due. Granted, with the Fed higher for longer, attractive short-end rates will likely persist into 2024. The situation where Treasury bills were purchased at 2% in December 2019 and reinvested at 0% in March 2020 should not be construed as a normal course of events. Should the funds rate trough at the Fed’s 2.5% long-term median dot, we could witness 2-handle T-bill yields as being the low point. The second consideration is the timing of Fed monetary policy. The peak of past hiking cycles has provided a good opportunity to lock in duration as intermediate bonds provide price appreciation potential. Third, from a cross-asset portfolio perspective, the short-end provides lower risk carry, but it does not provide the negative correlation to equities that comes with high-quality duration. As CIO has messaged, the short-end can provide the yield, but not the shield.
Q. With inflation declining, how will TIPS fare?
A. TIPS performed poorly in 2022, even with inflation running at very hot levels as real yields rose. Recently, the one-year forward inflation projections have moved substantially higher and TIPS declined by 1.4% in February. This is because real yields moved up and with 10-year real yields near 1.5%, we view them to be more fairly valued, even as disinflation continues. Despite the disinflationary trend, investors may receive the benefit of lower interest rates by year-end, leading to higher prices for TIPS.
Q. What is the historical default rate for investment grade bonds?
A. In the absence of black swan events, corporate bonds rated in the A or BBB categories rarely default. According to an S&P study that spanned 40 years, bonds rated BBB experienced a cumulative default rate of 5.5% over a 15-year timeframe. The more relevant risk for IG corporate bonds stems from credit rating downgrades. S&P’s four-decade study showed that about 7% of BBB’s got downgraded to BB over a three-year period. An additional 2% fell to B, 0.3% to CCC, and 0.9% to default. On the flipside, about 8% of BBB bonds got upgraded. Given these statistics, IG spreads primarily compensate investors for factors such as liquidity and rates volatility over default losses.
Q. Should I extend beyond short maturities in IG?
A. In addition to holding positions on the short end, we also view the current environment as providing a good opportunity to add to the intermediate 7-year sector in IG. The Treasury yield curve remains highly inverted but the corporate IG yield curve is relatively flat. This is because the credit spread curve is upward sloping with 1–3 spreads at 73bps but 7–10 year spreads at 158bps. Since credit stresses increase in occurrence over time, investors demand a higher spread for bonds with longer maturities.
Q. Does this mean that investors should go out as far on the yield curve as they can?
A. No, the spread pickup from 10 to 30 years is relatively flat. In previous work, we have shown that investors can capture the bulk of the performance benefits of the full IG asset class by sticking with intermediate duration of about 7–10 years, which includes 1–10 year bond ladders.
Q. CIO has a least preferred on HY bonds; should I avoid them?
A. HY bonds exhibit a stronger correlation to equities than is the case for higher quality fixed income sectors. HY credit spreads tend to be more vulnerable in cases where risk gets repriced into the marketplace. On a valuation basis, HY spreads are not factoring in more adverse outcomes in terms of economic growth or corporate earnings growth. Our sector preferences are instead focused on the yield that is attainable in IG corporates and agency MBS, where the risk-return profiles are superior. In the case of a growth scare, IG corporate spreads stand to widen less and the sector see more of a duration boost than is the case for HY bonds. But for investors with a higher risk tolerance, and who are willing to endure mark-to market volatility, we see justification for riding out the likely near-term downside risks given HY’s outright yield level. Also of some comfort is the fact that we have not seen the classic buildup of financial excess and leverage since the last default cycle in 2020.
Main contributors: Leslie Falconio and Barry McAlinden
Read the full report Fixed income strategist: Pathway reopens 8 March 2023.
This content is a product of the UBS Chief Investment Office.
