Are bonds cheap or expensive? A 5-point valuation checklist
Portfolio Managers Seth Meyer, John Lloyd, and John Kerschner discuss five key bond valuation metrics for financial professionals and portfolio managers.
7 minute read
- While equity investors typically consider valuation metrics when appraising the asset class’s relative cheapness, most bond investors have not adopted this approach.
- We believe bond investors would do well to consider valuation metrics as they determine how much to allocate to fixed income, and which sectors to allocate to.
- Here, we provide a five-point fixed income valuation checklist, which, in our view, shows that bonds are cheaper than they have been since 2008 and makes a compelling case for a strategic overweight allocation in multi-asset portfolios.
Poll a group of investors on their preferred equity valuation metric and you’ll likely be met with a consensus response: the price-to-earnings (PE) ratio.
Now, ask for the group’s preferred bond valuation measure and you’ll probably get anything but a consensus. Instead, everyone will likely pause for some inner pondering before responding with a bevy of different answers.
While investors typically track equity valuations on an asset class, style, sector, and security basis, this same approach does not often carry over to fixed income. Likewise, whereas most investors might have an opinion on whether equity securities are cheap or expensive, they do not tend to think about bonds the same way.
We believe bond investors would do well to consider valuation metrics as they determine how much to allocate to fixed income, and which sectors to allocate to. In our view, bringing valuation to the table may lead to better risk-adjusted returns in fixed income.
To provide a framework for this assessment, we highlight five key bond valuation metrics below.
1. Nominal yield
The first valuation tool bond investors may use is to simply consider the current yield to worst (YTW) on the Bloomberg U.S. Aggregate Bond Index (U.S. Agg). As shown in Figure 1, current YTW and 5-year annualized forward returns have been highly correlated for the U.S. Agg since 1992. Therefore, we believe investors would do well to pay attention to their starting yield.
Figure 1: Correlation between U.S. Agg YTW and 5-year annualized forward returns (1992-2018)
Source: Bloomberg, as of January 31, 2023. Period from January 31, 1992 to January 31, 2018.
While past performance does not guarantee future returns, we believe investors can look to current yield as a simple measure for predicting potential future bond returns. While no measure can work with absolute precision, it is worth noting that, following the sharp rise in yields in 2022, the starting YTW on the U.S. Agg is now in the 4.5% to 5% range. In our view, this currently makes the case for potentially better returns in fixed income than at any point since 2008, as shown in Figure 2.
Figure 2: U.S. Agg YTW and 5-year annualized forward returns (1976-2023)
Source: Bloomberg, as of January 31, 2023. U.S. Agg yield to worst period from January 31, 1976 to January 31, 2023. U.S. Agg 5-year annualized forward returns period from January 31, 1976 to January 31, 2018. Past performance is no guarantee of future results.
2. Real yield
While nominal yield is a helpful starting point, it does not tell us anything about fixed income’s ability to outpace inflation. The second metric we need to consider is real yield, or nominal yield less expected inflation.
As shown in Figure 3, since 2008, real yields on 5-year U.S Treasuries have been negative for the majority of the time. Consequently, bonds have had a hard time beating inflation over that period. But following the Federal Reserve’s (Fed) aggressive rate hikes in 2022, coupled with inflation starting to cool more recently, 5-year U.S Treasury bonds are now offering substantially positive real yields. In our view, investors do not necessarily have to turn to riskier assets like equities to beat inflation in the current environment.
Figure 3: U.S. Treasury 5-year real yield (2003 – 2023)
Source: Bloomberg, as of March 16, 2023. Past performance is no guarantee of future results.
3. Credit spreads
The yield on a fixed income security comprises two main elements: The yield on the risk-free government bond of similar maturity, and an additional yield, or credit spread, which is paid to investors to compensate them for the higher risk of the security.
While investors should pay attention to yields on government bonds, it is equally important to evaluate sector spread valuations in relation to their historical levels, as well as in relation to other sectors. In doing so, we can determine which sectors and individual securities look cheap relative to others, or cheap relative to their historical valuations.
As shown in Figure 4, spreads in securitized sectors are currently wider than spreads in corporate investment grade (IG) and high yield (HY). In our view, securitized sectors are presently offering better value relative to corporates, which we think could warrant maintaining an allocation to securitized assets.
Figure 4: Current spread percentile of historical spread range, excl. COVID (2010-2023)
Source: Bloomberg, Janus Henderson Investors, as of March 16, 2023. Indices used to represent asset classes: Corporate IG (Bloomberg U.S. Corporate Index), Corporate HY (Bloomberg U.S. Corporate High Yield Index), Securitized (Bloomberg U.S. Securitized: MBS/ABS/CMBS and Covered TR Index).
4. Bonds versus cash
Investors seeking interest income have an alternative to bonds in the form of bank savings accounts. We therefore need to evaluate bond yields relative to yields on bank savings.
Prior to the first quarter of 2022, there was little incentive for investors to consider risk assets as an alternative to cash. But the picture has changed dramatically in recent months as LIBOR and Treasury rates have risen sharply while rates on savings have hardly moved, as shown in Figure 5. An investor can now get over 4% of additional yield from a 1-month U.S. Treasury, or from LIBOR-based instruments such as AAA collateralized loan obligations (CLOs), making the case that bonds currently look significantly better than cash.
Additionally, while yields on short-duration fixed income have risen significantly, investors may only lock those yields in for the short term. If the Fed is forced to cut rates meaningfully, short-term bonds could underperform relative to long-term bonds. In our view, therefore, investors might consider pairing a short-term fixed income allocation with, for example, longer-dated U.S. Treasuries or agency mortgage-backed securities (MBS), which may help to defend a portfolio’s yield against the possibility of falling rates.
Figure 5: Banks are not passing higher interest rates on to depositors (Apr 2021 – Feb 2023)
Source: Bloomberg, FDIC, as of February 28, 2023.
5. Bonds versus stocks
The final valuation metric to consider is how bond valuations compare to equities – the asset class they’re most often paired with. In this case, we can evaluate the earnings yield on the S&P 500® Index versus the yield on a 6-month U.S. Treasury. Since 2008, the earnings yield on equities has far exceeded the yield on the 6-month Treasury, as shown in Figure 6. But here, too, the picture has changed significantly following the rate hikes in 2022 and 2023. These two yield measures are now close to parity – a situation we have not witnessed since 2001.
Investors who are concerned about a slowing economy or recession can now get a similar yield from bonds as they can from equities. Consequently, we think bonds are cheaper relative to equities than they have been in over 20 years.
Figure 6: U.S. Treasury yield versus S&P 500 earnings yield (2001 – 2023)
Source: Bloomberg, as of March 16, 2023.
Just as investors use valuation tools for their equity allocations, we think it is important to apply the same approach to fixed income. Doing so can help investors weigh the risk-reward of being overweight bonds as an asset class, and determine which sectors, durations, and individual securities they want exposure to.
Considering the five key metrics we just covered, in our view, fixed income looks cheaper now than it has in decades due to higher nominal and real yields and relative value to cash and equity.
10-Year Treasury Yield is the interest rate on U.S. Treasury bonds that will mature 10 years from the date of purchase.
Bloomberg U.S. Aggregate Bond Index is a broad-based measure of the investment grade, US dollar-denominated, fixed-rate taxable bond market.
Bloomberg U.S. Corporate Bond Index measures the investment grade, US dollar-denominated, fixed-rate, taxable corporate bond market.
Bloomberg U.S. Corporate High Yield Bond Index measures the US dollar-denominated, high yield, fixed-rate corporate bond market.
The Bloomberg U.S. Securitized: MBS/ABS/CMBS and Covered TR Index is an index that tracks agency mortgage-backed pass-through securities, investment-grade asset-backed securities, investment-grade commercial mortgage-backed securities and covered assets. The index is constructed by grouping individual pools into aggregates or generics based on program, coupon, and vintage.
Collateralized Loan Obligations (CLOs) are debt securities issued in different tranches, with varying degrees of risk, and backed by an underlying portfolio consisting primarily of below investment grade corporate loans. The return of principal is not guaranteed, and prices may decline if payments are not made timely or credit strength weakens. CLOs are subject to liquidity risk, interest rate risk, credit risk, call risk and the risk of default of the underlying assets.
Correlation measures the degree to which two variables move in relation to each other. A value of 1.0 implies movement in parallel, -1.0 implies movement in opposite directions, and 0.0 implies no relationship.
Credit Spread is the difference in yield between securities with similar maturity but different credit quality. Widening spreads generally indicate deteriorating creditworthiness of corporate borrowers, and narrowing indicate improving.
Duration measures a bond price’s sensitivity to changes in interest rates. The longer a bond’s duration, the higher its sensitivity to changes in interest rates and vice versa.
Earnings Yield measures earnings per share for the most recent 12-month period divided by the current market price of those stocks.
High-yield or “junk” bonds involve a greater risk of default and price volatility and can experience sudden and sharp price swings.
LIBOR (London Interbank Offered Rate) is a short-term interest rate that banks offer one another and generally represents current cash rates.
Price-to-Earnings (P/E) Ratio measures share price compared to earnings per share for a stock or stocks in a portfolio.
Securitized products, such as mortgage- and asset-backed securities, are more sensitive to interest rate changes, have extension and prepayment risk, and are subject to more credit, valuation and liquidity risk than other fixed-income securities.
S&P 500® Index reflects U.S. large-cap equity performance and represents broad U.S. equity market performance.
U.S. Treasury securities are direct debt obligations issued by the U.S. Government. With government bonds, the investor is a creditor of the government. Treasury Bills and U.S. Government Bonds are guaranteed by the full faith and credit of the United States government, are generally considered to be free of credit risk and typically carry lower yields than other securities.
Yield to worst (YTW) is the lowest yield a bond can achieve provided the issuer does not default and accounts for any applicable call feature (i.e., the issuer can call the bond back at a date specified in advance). At a portfolio level, this statistic represents the weighted average YTW for all the underlying issues.
Equity securities are subject to risks including market risk. Returns will fluctuate in response to issuer, political and economic developments.
Fixed income securities are subject to interest rate, inflation, credit and default risk. The bond market is volatile. As interest rates rise, bond prices usually fall, and vice versa. The return of principal is not guaranteed, and prices may decline if an issuer fails to make timely payments or its credit strength weakens.
Index performance does not reflect the expenses of managing a portfolio as an index is unmanaged and not available for direct investment.