Finding Value in Bonds

When global yields were at their nadir, many investors winced at the thought of investing in bonds, befuddled by a market where yields on $18 trillion of securities had fallen into negative territory.

If you are one of those investors and you have been either underweight bonds or avoiding them completely, it may be a good time to start considering bonds again. Valuations look attractive, especially when viewed through a long-term lens that focuses on the traditional benefits of owning fixed-income securities:

• Income
• Diversification
• Preservation of principal

To be sure, yields and spreads could well increase further in response to a variety of influences. Yet I think it better to put current valuations in the context of the fullness of a market cycle rather than an uncertain short-term outlook. I also believe it’s important to avoid attempting to time the diversification benefits of bonds, especially when yields look attractive relative to prospective volatility for the asset class. 

Yields have risen significantly this year, and cracks are showing in other asset classes, which might be good news for high-quality bonds. The cracks suggest that the Federal Reserve’s handiwork is beginning to transmit beyond the bond market, and that bonds may now have a better chance of self-stabilizing (see my previous newsletter on this point). 

Searching for value in today’s bond market

Investors might benefit from the broadness of this year’s sell-off, which has resulted in a wider selection of bonds to fit their individual needs and objectives – both in terms of the types of bonds they might want to own and the risk factors inherent in them, which can play an important role in balancing an overall portfolio. 

In the context of the above, here now are a few areas of the fixed-income markets that appear attractive:

Core bonds: Highlighting the increased allure of fixed income is the current yield-to-worst for the Bloomberg U.S. Aggregate Index, which at around 3.5% is roughly double where it stood at the start of the year (as of May 16, 2022). That yield looks attractive relative to a number of important portfolio considerations, including the historical volatility of the Aggregate, expected inflation (as measured by the Fed’s 5-year/5-year breakeven inflation rate), and the general principles of portfolio diversification. 

Agency mortgage-backed securities (MBS): Throughout 2022, many investors have reduced their allocation to MBS, believing that an end to the Federal Reserve’s bond buying would ultimately harm the segment, which it did. That, combined with an increase in interest-rate volatility, which is the bane of the MBS market, caused MBS yield spreads to widen sharply to levels rarely seen over the past two decades. Now, that story has largely played out, with news of the Fed’s plan to reduce its MBS holdings significantly factored into market prices. Those improved valuations can help an investor to focus on the longstanding attractiveness of MBS from a credit and liquidity perspective, making this year’s significant spread widening — both nominally and on an option-adjusted basis — look like an opportune time to consider adding exposure to MBS.

Other collateralized securities: In addition to MBS, there appears to be value in a number of collateralized securities, including those in commercial real estate, seasoned non-agency MBS, and collateralized loan obligations. In the residential real estate market, credit metrics continue to look favorable, highlighted by low loan-to-value ratios in the U.S. 

Debts of financial companies: Banks withstood an array of stresses at the onset of the Covid-19 pandemic, in many cases bolstering their capital ratios, providing an increased buffer for investors in their debt. Yield spreads in senior debt of financial companies look particularly attractive, as do spreads on bank-capital securities, especially when the credit ratings of those securities are compared to those in the high-yield bond market, where price volatility tends to mirror bank capital.

Municipal bonds: For individual investors, yield ratios on 10- and 30-year AAA-rated municipal bonds are now around 100% of equivalent Treasury yields, up from about 70% earlier in the year. For individuals in high tax brackets, tax-equivalent yields therefore may be north of 5%. Municipal bond funds have seen significant outflows amid this year’s volatility. Yet munis tend to perform well late in an economic cycle, because they tend to have low correlation to risk assets such as equities. They also have a lower historical default rate than similarly rated corporate bonds. For investors that can tolerate higher volatility, some parts of the muni high-yield market look attractive, including affordable housing, tobacco, and some Puerto Rico bonds. 

Low-duration and short-term investments: Today’s flat yield curve means that investors needn’t step far out onto the curve to seek income that is on par with longer maturities. The significant repricing of short-term yields for future Fed rate hikes now provides investors with a cushion against further interest rate increases, especially in maturities under two years. With a duration of about 2.0 years, a two-year Treasury yielding about 2.7% would have to see that yield increase more than 125 basis points (bps) before an investor would have a negative return in a year’s time. For investors leery of rising rates but wanting to capture today’s higher yields, short maturities may be an appealing option. 

Private assets: Outside of the public markets, expected returns in private markets such as private credit still look attractive, though it is important to be increasingly discerning in the area given the many downside risks associated with the macroeconomic climate as well as the lag in spread behavior relative to that of the public markets. There are other risks, including the smaller size of the borrowers, their increased equity risk, and the potential for more lax risk management compared with public companies. Don’t fall for the common misconception that private debt is less risky than public debt; in fact, borrowers in private credit markets generally offer as much (and in some cases more) fundamental risk than those in the high yield bond and bank loan markets. Private assets nonetheless still have allure when considering their illiquidity and complexity premiums, which in many cases significantly exceed those found in public markets, chiefly because of differences in their accessibility.

Turning to risk factors, recent changes in market valuations may warrant consideration of the following ideas for fixed-income investors: 

• A reduction to underweights in portfolio duration, in some cases via a reduction to underweighting of agency MBS, especially in portfolios having relatively high amounts of equity and credit beta
• An increased preference toward shorter maturities — positioning for a steeper yield curve given the waning impact of the so-called term premium effect that caused longer-term yields to be suppressed by the Fed’s quantitative easing, which has now moved in reverse
• Opportunistic selling of option volatility, given the significant repricing of interest rates that has taken place in anticipation of future Fed rate hikes
• Continued caution on credit with an up-in-quality bias
• Cautiously scaled investments in the emerging markets (EM), with a focus on viewing EM assets as portfolio diversifiers

In summary

There is an old adage in the financial markets that I tend to adhere to:

             Be a liquidity provider, not a taker.

Today, this adage means scooping up securities that many investors have shunned and where this year’s tumult may have created long-term value. In that context, investors may want to start to consider cautiously stepping back into bonds. 

Tony Crescenzi is a market strategist and portfolio manager at PIMCO and is also a member of the firm’s investment committee. Click here for more about Tony.

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