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Investing in a Rising-Yield Environment

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Andrew R. Michaud

• October 03, 2023

The year 2022 brought about a significant interest-rate reset, causing pain for many investors. However, there is now some relief to be found as higher yields emerge across the fixed income spectrum. One area in particular that has reaped the benefits is money market funds, which saw massive inflows in 2023. Although these funds offer relatively attractive returns, it may be wise to explore other segments of the market as we approach the peak of the Federal Reserve's rate hiking cycle.

While it's tempting to solely focus on the appealing yields of money market funds, it's important to remember that fixed income has another important role to play within a multiasset portfolio: defense. Bonds, for example, can act as ballast during equity drawdowns. While money market funds may not lose ground in the event of an equities pullback, they are unlikely to experience the price appreciation that longer-duration bonds potentially can. This appreciation can help counterbalance any potential declines in equities.

The possibility of a scenario like this should not be dismissed outright. There are indications that the economy is slowing down, and when coupled with 18 months of consecutive Fed rate increases and still-strong equity valuations, stocks become vulnerable to a significant drawdown. In this context, it becomes increasingly important to consider the role of fixed income investments, such as bonds, to safeguard a portfolio against potential downturns.

Investors should carefully evaluate the various options available and weigh the potential benefits of money market funds against other fixed income securities. By doing so, they can position themselves effectively to navigate the current rising-yield environment and mitigate any potential risks that lie ahead.

Embracing Duration

Timing Matters

Historically, it has been observed that adding duration to fixed income allocations during periods when short-term rates peak can be beneficial. Analysis of the past six rate-hiking cycles reveals that duration assets have outperformed money markets once policy rates reach their zenith in five of these cycles. In only one instance did duration assets perform in line with money markets. This trend can be explained by the fact that peak rates are typically followed by a cooling economy and subsequent rate cuts. Consequently, rate-sensitive segments of the bond market, such as government bonds and investment-grade corporates, tend to benefit under these circumstances.

A Plateau in Yields

Even if the Federal Reserve does not immediately initiate rate cuts, it is likely that the yields of mid- to longer-dated bonds are plateauing. Therefore, the next sustained move in yields is expected to be lower. Furthermore, the decreasing inversion of the U.S. Treasuries yield curve indicates that bond investors will not sacrifice much in potential returns by adding duration to their portfolios. Instead, they can position themselves for a higher degree of capital appreciation, especially if the economy continues to slow down.

Quality within the Right Segment

As we look ahead, the maturity wall until 2025 does not present a significant challenge. However, companies are beginning to consider refinancing about 12 months before their issuance matures. Taking advantage of the low interest rates, many companies have bonds that mature gradually over several quarters. So far, they have managed to handle the sudden increase in rates. However, there is cause for concern regarding companies with a substantial amount of floating rate debt or large fixed debt that will require refinancing.

Businesses with weaker financials are also a point of concern, especially considering that we are now 18 months into a historic rate hiking cycle. Struggling companies not only face the difficulty of an economic slowdown but also tighter credit conditions. This creates a significant problem for those who need to refinance in the near future.

Although credit spreads on high-yield bonds remain close to historical averages, there is a possibility of them widening. To ensure success, it is crucial to have a comprehensive understanding of a borrower's fundamentals and stay on the right track.

Securitized Credit Valuations and Security Selection

Securitized credit valuations, especially agency mortgage-backed securities, have demonstrated a quicker response to a slowing economy. Just like corporate issuance, the selection of securities becomes even more crucial during this stage of the cycle. While signs of stress may not be evident across all industries, winners and losers will emerge in every sector. Therefore, investors have the potential to reap rewards by increasing their bond allocations for the rest of the year. However, it is essential to prioritize higher-quality issuance and extend duration for maximizing returns.