Written by: Keith Bachman | Allspring
The U.S. yield curve looks attractive for the first time in over a decade, and core fixed income yields now have ample cushion to once again meaningfully offset declines from other assets within diversified portfolios.
- Last year’s pain may be this year’s opportunity: Receding inflationary pressure and the trajectory of Federal Reserve (Fed) rate policies could likely be tailwinds for core fixed income.
- After years of artificially low interest rates, this is the highest-yielding environment we’ve seen since 2008.
- Rising high-quality core fixed income yields now have ample yield cushion to buffer declines in other assets within diversified portfolios.
What is core fixed income, and what’s its purpose?
The term “core fixed income” applies to investment-grade bond portfolios that seek to preserve capital while also delivering consistently positive returns and noncorrelation benefits relative to riskier assets. Typically, they provide broad exposure across the U.S. yield curve and can include U.S. Treasuries, other government-related bonds, investment-grade corporate bonds, and securitized sector bonds.
Common objectives for investment-grade fixed income are to deliver price and income stability, principal protection, and consistent returns. When combined in a diversified portfolio with other assets—such as high yield bonds (represented by the Bloomberg High Yield Index), emerging market equities, and U.S. equities (represented by the S&P 500 Index)—core fixed income historically has tended to provide inverse correlations to stocks and enabled investors to pursue an optimal return profile at a prescribed level of risk. This relationship is illustrated in Chart 1, where we’ve highlighted asset class returns during five periods of equity market weakness. In these periods, core bonds’ positive return stream (represented by the Bloomberg U.S. Aggregate Bond Index) meaningfully offset negative returns from U.S. stocks—and from high-yield bonds, which tend to correlate with stocks.
Core fixed income portfolios are commonly benchmarked to the Bloomberg U.S. Aggregate Bond Index because it’s a proxy for the broad universe of high-quality U.S. investment-grade bonds. Since its inception in 1976, this index has produced positive returns in 42 of the 45 years.
However, after decades of relatively stable and mostly positive returns for the Bloomberg U.S. Aggregate Bond Index, its 2022 return declined markedly (Chart 2)—setting the stage for potentially outsized opportunities in the years ahead as conditions normalize and Fed policy decisions become less restrictive.
Massive stimulus required during and after the pandemic profoundly affected fixed income portfolios.
Unprecedented stimulus in the U.S. and overseas and a generation of low rates took a severe toll on traditional portfolio construction as investors struggled to meet fixed income return hurdles in the low-rate environment. One fallout from this development was that investors deemphasized the U.S. core fixed asset class. They piled into credit-heavy strategies and even down-in-credit, non-investment-grade, and private capital opportunities searching for yield, instead of investing in what historically had been the keystone of a diversified portfolio: traditional core fixed income.
A new, improved yield environment: Core fixed income is back!
As inflation took off in early 2021, the years of artificially low rates ended in dramatic fashion, and the Fed ended quantitative easing and began raising rates. The dramatic rise in yields during 2022 pressured not just bond prices, but also the S&P 500 Index, which moved into bear market territory on fears of a slowdown. Thus, the typically negative correlations between bonds and riskier assets broke down. As a result, fixed income allocations didn’t serve as a buffer or diversifier in 2022.
But now, the U.S. yield curve looks attractive for the first time in over a decade. Yields have risen from historic lows and are now back to pre-stimulus levels. While Fed actions and inflationary pressures were certainly headwinds to fixed income returns in 2022, we believe we’ll see a modest tailwind effect for 2023 and 2024 as rates and the yield curve begin normalizing amid a decelerating inflation trajectory and possible Fed rate cuts.
With the recent dramatic repricing of the U.S. yield curve and broadly higher bond yields, we believe traditional fixed income is once again poised to perform the way investors have come to expect. They expect the potential for high current income and price stability as the Fed moves to wind down its hikes—and, importantly, a return to negative correlation with equities given the increasing cushion within bond yields.
Indeed, on days of extreme stress in equities, we’re beginning to see fixed income and other haven assets move inversely relative to riskier assets. Investors employing a core fixed income allocation at these new yield levels could soon be benefiting from a prudent portfolio diversification approach that incorporates core fixed income.
Truth in labeling: Know what you own in fixed income.
An investment-grade benchmark like the Bloomberg U.S. Aggregate Bond Index can provide a reference point for investors who want high-quality fixed income assets to form the core of their bond portfolios. In all cases, investors should examine whether the bond strategies under their consideration possess the quality and liquidity characteristics of the benchmark as a whole. Otherwise, the benchmark’s characteristics—including risks and returns—may not be relevant.
For example, a traditional core bond strategy that drifts into other, more aggressive holdings—such as heavier allocations to off-benchmark sectors like high yield and bank loans—may not retain the quality and liquidity characteristics that are needed to deliver the volatility-minimizing role that was intended. So, knowing what you own in fixed income is important.
What’s a likely winning formula for core fixed income?
We believe that due to the nature of the asset class and the common objectives investors who allocate to core fixed income are seeking, the risk of a core portfolio needs to be firmly in line with its benchmark’s risk—ultimately with the goal of achieving or exceeding the returns of the high-quality Bloomberg U.S. Aggregate Bond Index.
In recent years, many managers outperformed this index by exploiting macro-opportunities—for example, by getting long credit spreads and shorting rates. However, we believe these levers are no longer available to core fixed income managers given the Fed’s tightening mode that’s likely to persist. In practice, very few investors are good at predicting the movement of interest rates and other macro factors, so macro bets on duration or curve or ill-timed allocations into riskier sectors like high yield may lead to downside performance surprises for investors. Considering the current level of volatility and security-level dispersion across markets, we believe bottom-up security selection combined with an active rotation of the portfolio is likely the winning formula in this new regime.
We suggest investors consider lower tracking error, active management strategies focused on security selection for alpha. Given persistent inefficiencies within fixed income markets, excess returns through security selection are replicable, and a steadfast focus on risk-adjusted returns or information ratio should ensure truth in labeling for investors targeting a “vanilla” core bond strategy—a true portfolio ballast.