We noted in our 9/30/23 Focal Point: Buried Bonds Can Come Back to Life that “despite recent poor performance, there is reason to be optimistic about Fixed Income: risk adjusted potential looks better… the recent period of rising rates has been bad for Fixed Income investors who invested three years ago, but it sets the table for a better environment going forward. Facing continued uncertainty and volatility in the economy, it would be helpful if Buried Bonds Can Come Back to Life, and return to their historic role of providing income, diversification, and risk reduction to investor portfolios.”
The record 7% jump for the Agg, highlighted in the prior section, was not exactly what we had in mind, but it shows how a reasonable yield relative to duration can set the table for better performance from Fixed Income. Duration measures the sensitivity of a bond’s price to changes in interest rates, with the value representing the percent change in a bond’s price for a 1% change in rates. For example, a bond with a duration of five would lose 5% if interest rates rose 1%.
Chart 1 above shows the yield, duration and ratio of duration to yield of the Agg back to 2000. Why would this matter to an investor? If yield is what you can earn in a year, and duration is the sensitivity of price to a 1% change in yield, then duration to yield is the number of years it would take to earn back the loss in value from a 1% increase in rates.
By the end of 2020, Aggressive Fed action to counteract the Covid pandemic, paired with investor fear of a global recession, combined to push the yield on the Agg down to 1%, and the duration/yield ratio jumped from 3 to 7. This meant that by the end of 2020, it would have taken 7 years of that 1% yield to offset the potential loss of just a 1% rise in interest rates. This is, of course, the reading right before the poor bond period of 2021-2023. A historically high duration/yield clearly preceded the historically poor 3 year period of returns.
Moving to the end of Q3’23, the yield had jumped to 5% and the duration is down to about 6.5, putting the duration/yield ratio at 1.2, and the best level since before 2010. This set the stage for Q4’s bond market rally. Even today, at the end of Q4’23, and with the Agg yield down to 4.5% from 5.4%, the 1.5 duration/yield ratio suggests bonds are reasonably priced, and at least have the potential to offer some portfolio diversification.
However, it’s not perfect: strong economic growth or stubborn inflation could push rates higher with, for example, the 10yr Treasury heading back towards 5% from 3.88%. A similar 1% move in the Agg’s yield would, based on its duration of 6.5, suggest there is price downside risk of about 6%. But the 4.5% yield would allow income to balance that and minimize losses to about breakeven (over a year, to collect that yield) in such a scenario. Should economic growth come up short, rates would decline, and investors would receive some price appreciation to go along with the yield.
It Did Not Take Long to See the Duration Benefit of Higher Bond Yields. Due to Q4’23’s major move in the bond market, Fixed Income’s outlook is not ideal for all scenarios. But it does still offer decent diversification potential to a portfolio.
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