Bonds: Treasuries And High-Grade Corporates Hold Greater Appeal After Recent Back-Up In Yields
October 2024
After five consecutive positive months out of the Bloomberg Aggregate Bond index, Treasury yields were strongly hinting at a potentially pronounced economic slowdown as October began. However, those fears have faded as more recent economic and labor market data point to an orderly slowdown back toward pre-COVID trends, not an economy at risk of a recession.As a result, market participants have been forced to ratchet up their economic growth and inflation expectations, thus putting upward pressure on yields across the Treasury curve. At the time of this writing, the 10-year yield is now back above 4%, a level last seen in late July, providing investors looking to lock in longer-term yields with a far more appealing income stream relative to the yields closer to 3.6% seen in mid-September closer.. The move higher in Treasury yields has pulled corporate bond yields higher as well, and the Bloomberg Investment Grade Corporate Index now carries a yield-to-worst of just shy of 5%. That yield-to-worst may not seem too impressive given where even money market yields have been over the trailing 12- to 18-months. But, with the FOMC expected to cut the funds rate further in the coming months, investors looking to lock in yields a few years out at/around the current Fed funds rate may find a lot to like in higher quality corporate bonds. It’s worth mentioning that with a yield just shy of 5% at present, investment-grade corporate bonds are one of the few segments of the fixed income market with a current yield above the 30-year average for the asset class, even if it is by just a handful of basis points.
October Volatility Could Bring About Better Valuations, Opportunities In High Yield. September was a rocky month for high yield corporate bonds but falling U.S. Treasury yields contributed to a 1.6% gain for the Bloomberg U.S. Corporate High Yield Index as credit spreads round-tripped and ended the month virtually unchanged. Treasury yields have reversed course and moved higher so far in October while interest rate volatility has also contributed to elevated equity volatility with the CBOE Volatility Index, or VIX, rising to above 20 to start the month, evidence of increased demand for put options to hedge against a drawdown in stocks. Interestingly, while equity volatility has increased, which tends to happen when investors fear a selloff and risk appetite wanes, high yield bonds have held up surprisingly well amid the turmoil. The credit spread over comparable duration U.S. Treasuries for the U.S. Corporate High Yield Index was just 283-basis points at the time of this writing, a year-to-date tight level and evidence that investors still require little in the way of compensation for taking credit risk in the current environment. With quarterly earnings season beginning and less than one month remaining until election day, we expect volatility in stocks to remain elevated in the near-term, which could bring about widener credit spreads and a modest improvement in valuations for higher yielding corporate bonds.
Emerging Market Debt Still An Appealing Option, But Total Return Potential More Limited From Here. The Bloomberg Emerging Market (EM) USD Aggregate Bond Index returned 1.7% during September, taking its year-to-date total return to 8.1% and its trailing one-year total return to a jaw-dropping 16.9%, with the index outperforming the Bloomberg U.S. Corporate High Yield index over each time frame. After such a sizable year-to-date gain and an equity-like trailing one-year return, it’s reasonable to ask how much upside might be left from exposure to this ‘non-core’ segment of the fixed income market and whether investors would be best served to take gains and look elsewhere for bargains. For context, the yield-to-worst on the Bloomberg EM USD Agg was 8% at the end of the Q3 2023 and 7% at the end of last year, well north of 6.28% as September ended. The yield-to-worst on an index provides a reasonable baseline for expected forward return, but when it comes to credit-sensitive and liquidity-reliant segments of the fixed income market such as high yield corporate bonds and emerging market debt, one must also take default expectations into account. In this case, the fundamental outlook for USD-denominated emerging market debt has improved over the past year.
Issuers such as Argentina, Brazil, and Saudi Arabia, among others, who make up a meaningful portion of the EM USD index have convinced market participants that they will rein in spending and be better stewards of investor capital moving forward and have seen their bonds rally as a result. With some of the largest issuers of EM debt expected to be in better fiscal shape, investors have ratcheted their expected return for the asset class higher, and with ample global liquidity finding its way into higher yielding assets, EM debt is on pace to exceed our lofty expectations for the asset class at the start of this year. With the EM USD Agg Index yielding 6.28% at month-end, we expect to squeeze another 1.5% or so out of the asset class between now and year-end, but credit spreads could narrow as sentiment improves, particularly should China follow up with additional stimulus measures, and the index could do a bit better than we expect when all is said and done. However, gains have been pulled forward with the asset class effectively generating two years of expected returns over the trailing twelve months, and with a yield-to-worst approximately 175-basis points below where it was one year ago, investors likely need to temper expectations for EM debt going forward.
As of October 9, 2024
