High returns from high yield
On the bond side the clear winners have been leveraged and high-yielding fixed income assets which sit right on the efficient frontier – the highest expected return for a given level of risk, or vice versa. Indeed, when I rank returns against realised volatility, high yield bond assets sit among the best quality investments with growth equities. This makes sense given the strong correlation between high yield and equity returns. What the long data series shows is that despite some shocks to the world economy (COVID-19, Russia’s invasion of Ukraine and the end of quantitative easing), investors have been rewarded for taking higher levels of investment risk. Today we have some concerns about valuations in high yield and what that suggests for excess returns (the return above government bonds). But yields are still attractive, and outside of a duration shock related to an acceleration of global inflation, this remains an attractive asset class.
Duration has disappointed
For most of this period, interest rates have been very low. They went up in 2022 and that was a massive headwind for fixed income asset returns. Low income returns during the decade after the financial crisis and then a big revaluation through the monetary tightening has left long-term returns from long duration assets as some of the most disappointing, with returns from very long-duration government bonds being volatile as well. It is difficult to see that changing. Bond yields are higher but at around 4% for US Treasuries and UK government bonds – gilts – and around 2% for German Bunds, returns are not going to be exciting. The case for duration is therefore one based on hedging equity and credit risk, or looking for tactical above trend returns when the economy is weak. Over the period, the correlation of returns between the Nasdaq 100 and over 10-year maturity US Treasuries has been close to zero, and despite the experience of 2022, bond yields are now high enough to make a typical mixed equity and bond portfolio potentially less volatile than a pure equity one.
Range trading in rates
Interest rate curves remain the bedrock of valuation across financial markets and the best guess for the time being is that (official) rates are not going up. There are relative value differences between implied forward interest rates and current government bond yields and that will allow tactical trading of government bond assets. It is another consensus view that the 10-year US Treasury yield is close to fair value and will remain in its current range for the near future. Against that, UK gilts look more attractive today.
Income focus, with lower risk
The final group of assets is one I have termed as high grade and short duration credit. This is where returns are balanced between credit spreads and interest rate returns. This has meant a decent balance between return and volatility in recent years. Full market investment grade indices have delivered returns of around 5% in the US and UK and slightly less in Europe – albeit better and less volatile than government bonds. A short duration exposure has meant less volatility and slightly lower annualised returns. Given that credit curves are positively sloped, this is likely to continue to be the case. But for risk averse investors, short duration should be something that allows potentially restful nights.
