After an extended period of accommodative monetary policy, major central banks have ramped up their hawkish rhetoric to normalize policy by rapidly raising rates and shrinking their balance sheets. These moves, coupled with geopolitical concerns have translated into a sharp repricing higher of interest rates across the yield curve and a widening of risk premia. According to Tony Appiah, fixed income specialist at UBS Asset Management, there are nevertheless three reasons for optimism for bond investors.
- Over the long-term, yield is by far the most stable and reliable component of total return for bonds.
Over the past 20 years, yield (income) has been the dominant driver of total returns in bond portfolios, as evidenced in the chart below. For certain asset classes such as high yield and emerging markets, price return has been negative over the long term yet performance has been positive and very strong, demonstrating the power of yield.
Despite the large role yield plays in total return, it only contributes a minor proportion towards total return volatility. From the below chart – which simplistically displays yield and price as a proportion of total return volatility – we can see that while yield has contributed the most to total return over the past two decades, it has done so while contributing a lower percentage to the overall volatility. This high return and low volatility aspect of yield makes the recent increase in yield (income) a reason for investors to be cheerful.
- Higher break-evens (from higher yields) act as “shock absorbers”.
In general, the higher the level of yield, the larger the magnitude of rate increases required to generate a negative total return (i.e., wipe out positive contribution from income). Take the Bloomberg Global Aggregate 1–3 Year Index for instance, at the end of 2021, this proxy for conservative fixed income investing required just a 38 bps rise in bond yields to generate a negative return. As a result of “income coming back to fixed income”, this same benchmark now requires nearly 127 bps of yield increases to erase its higher yield advantage.
- Investors no longer need to reach for yield by taking unnecessary credit risk.
In a regime of ultra-low government bond yields and steep yield curves, investors in developed markets bonds were faced with a rather difficult trade-off: generate higher yields by going out longer on the curve and taking on more interest rate risk, or dip down the credit quality spectrum and be saddled with higher credit risk. As the below table shows, only as recently as December of 2021, the only major developed market fixed income asset class offering yields of 2% or higher in the all-encompassing Bloomberg Multiverse Index was global high yield. Today, on average, each major fixed income asset class offers a yield equal to or greater than 2%. Investors can therefore potentially build a globally diversified portfolio with an attractive level of income.
Here you'll find the complete report 'Three benefits of higher income in fixed income' from UBS Asset Management.