Is There a Place in Portfolios for Fixed Income?

The widely held assumption as we enter 2017 is that this will be the year we see the Fed take real action.  While we aren’t convinced that longer term (5 and 10yr) Treasury rates move much further from where we closed out the year given the global demographics and economic headwinds (see our piece, “The Election Impact on the High Yield Market: Rates and Regulations”), for those concerned about rates, is there a place for fixed income investing?

We ended 2016 with the 5-year Treasury yield at 1.93% and the 10-year at 2.45%, which is up a mere 20bps from where we ended 2015.  However, over the course of the year, it was a wild ride for Treasuries.  Yields fell as low as 0.94% on the 5-year and 1.37% on the 10-year in early July 2016 and spiked as high as 2.07% and 2.6%, respectively, in mid-December.1  However, over that period from early July to the end of December when we saw rates climb more than 110bps, the high yield bond market had a strong performance, up 6.79% over that nearly six month period.2


The same cannot be said for other areas of fixed income.  Investment grade and municipal bonds both had negative returns over the same period in the face of rising rates.3


We have noted time and again in our writings, high yield bonds have historically performed well during periods of rising interest rates (as measured by Treasury yields), and the last six months again supports that (see our writings, “Strategies for Investing in a Rising Rate Environment,” “High Yield in a Rising Rate Environment,” and “The Election Impact on High Yield: Rates and Regulation” for further data on high yield bond market performance as rates increase).  However, with their higher correlation to Treasuries, lower starting yields, and higher duration, investment grade corporates, municipals, and other areas of fixed income are much more exposed to interest rate moves.4


Whether rates rise or not, we don’t see investment grade corporates or municipal bonds as an attractive investment option as we sit today.   Here you are faced with yields that are nearly half that of those offered by the high yield market and much higher interest rate risk given the average maturity profile is four or more years longer.

Looking back over the last 25-year history, the high yield bond market has had a 160-260bps return advantage over investment grade and munis, and we don’t see anything that would change that return advantage going forward.5


The gut reaction of investors seems to be to flee fixed income at the first hint of an increase in interest rates.  We would see this as a valid reaction for many areas of the fixed income market, but not for high yield debt.  With what we see as an attractive yield relative to other areas of fixed income, we believe high yield bonds have a place in investment portfolios going forward, irrespective of what happens with interest rates.

1  The 2016 low was on July 5, 2016.  Other data as of 12/31/15 and 12/31/16.  Data sourced from U.S. Department of Treasury.
2  Bloomberg Barclays US High Yield Index covers the universe of fixed rate, non-investment grade debt.  Data for the period of 7/5/16 to 12/31/16 source Barclays Capital and U.S. Department of Treasury.
3  Bloomberg Barclays Corporate Investment Grade Index consists of publicly issued U.S. corporate and specified foreign debentures and secured notes that meet the specified maturity, liquidity, and the quality requirements (source Barclays Capital). Bloomberg Barclays Municipal Bond Index covers the long-term, tax-exempt bond market (source Barclays Capital).  Cumulative returns presented, for the period 7/5/16 to 12/31/16.
4  Data as of 12/29/16, source Bloomberg and Barclays Capital.  Yield to Worst is the lowest, or worst, yield of the yield to various call dates or maturity date. Duration is the change of a fixed income security that will result from a 1% change in interest rate. The duration calculation is the modified adjusted duration for the indexes and Bloomberg calculated duration to workout for 5-Year and 10-year Treasury.
5  Data covers the period 12/31/1991 to 12/31/2016, data sourced from Barclays Capital.
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