Fixed maturity bond portfolios: Harvesting income opportunities
James Briggs, Carl Jones and Tim Winstone, fixed income portfolio managers, look at the historically attractive yields on offer from bonds and why now may be a potentially opportune time to lock in income.
5 minute read
- Yields on corporate bonds – including those with shorter maturities – are competitive even with the earnings yield on equities, something that has rarely happened in the last 20 years.
- Investors have a rare opportunity to capture nearly all the income of the investment grade corporate bond market without having to stretch for maturity.
- A fixed maturity bond portfolio offers a vehicle for investors to lock in income while benefiting from reduced concentration risk through a diverse portfolio.
In a previous article we highlighted the attractiveness of the yields on offer from corporate bonds from a historical perspective. Yields have since crept up and a revised version of the chart is shown below. Yields are at a level that compares favourably with yields available across the last 20 years.
Figure 1: Yield on global investment grade corporate bonds
Source: Bloomberg, ICE BofA Global Corporate Index, yield to worst, 31 December 2009 to 31 August 2023. The ICE BofA Global Corporate Index tracks investment grade corporate debt publicly issued in the major domestic and Eurobond markets. 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). Yields may vary over time and are not guaranteed.
The upward pressure on yields has principally come from a rise in sovereign bond yields. Factors that have contributed to the rise include stronger-than-expected economic growth in the US; tension in the Middle East creating fresh concerns about the price of oil and the pace of disinflation; and a renewed focus on demand and supply given that elevated fiscal deficits are having to be funded by more price-sensitive buyers now that key central banks are engaging in quantitative tightening (reducing their holdings of government bonds).
Credit spreads (the additional yield over a government bond of the same maturity) have gapped marginally wider as the benefits of potentially stronger economic news are offset by higher financing costs and geopolitical fears. Taken together, the tightening of financial conditions is ultimately going to slow the economy – something that members of the US Federal Reserve (Fed) have been vocal in recognising. Commentators from investment banks reckon the recent tightening in financial conditions since the September FOMC meeting is equivalent to as much as three 25 basis point hikes by the Fed.1
Unsettled markets mean the timing and pace of interest rate cuts by the Fed and the European Central Bank have swung around but markets remain convinced that cuts will start in the middle of next year.2 Tighter financial conditions could, if anything, prompt deeper cuts if they lead to a faster-than-expected economic slowdown.
The rise in bond yields means that not only are bond yields at relatively high rates historically, they also compare favourably against equities. Equities do not typically pay out their full earnings, so the dividend yield is normally below the earnings yield. What is interesting about the current climate is that even at the higher earnings yield, equities – which are viewed as a higher risk, more volatile asset class – are offering barely any premium to investment grade corporate bond yields. This is unusual in history as Figure 2 shows.
Figure 2: Yield on global equities and investment grade (IG) corporate bonds
Source: Bloomberg, Earnings yield and dividend yield on MSCI World Index (equities). The MSCI World Index is an equity index that tracks the performance of large and medium-sized companies across 23 developed market countries. ICE BofA Global Corporate Index, ICE BofA 1-5 year Global Corporate Index, yield to worst, definition as for Figure 1. The ICE BofA 1-5 year Global Corporate Index is a subset of ICE BofA Global Corporate Index including all securities with a remaining term to final maturity less than 5 years. 30 September 2003 to 19 October 2023. Yields may vary over time and are not guaranteed.
Figure 2 also demonstrates that investors do not have to stretch their maturity horizon to achieve a high yield – nearly all the yield available from the global investment grade corporate bond market can be achieved by investing in shorter-dated (sub 5-year) bonds. Again, this is a rare opportunity and one that may not be around for long.
Provided a corporate bond does not default, an investor can be fairly confident of the return they will receive if a bond is held to maturity. There is always a risk, however, that a borrower could get into trouble and default and this could occur at any time. The following table demonstrates that the combination of a higher credit rating (investment grade BBB or higher) with a sub-5-year horizon has historically represented a low default incidence. Investing in lower rated bonds can bring rewards but the greater risk of default means more careful assessment of a borrower’s credit fundamentals is required, together with a more selective approach.
Figure 3: Global corporate average cumulative default rates (1981-2022) %
Source: S&P Global Ratings Credit Research & Insights and S&P Global Market Intelligence Credit Pro. Default, Transition and Recovery: 2022 Annual Global Corporate Default and Rating Transition Study, April 2023. AAA to BBB represent investment grade credit ratings, while BB to CCC represent speculative grade credit ratings. Past performance does not predict future returns.
Investors could seek to lock in today’s yield by buying an individual bond, but we think that a fixed maturity bond fund would be a less risky route. Just like an individual bond it has a regular coupon and fixed maturity date but comes with the added benefit of diversification across a portfolio of bonds. Furthermore, credit selection is undertaken by a team of experts, who will monitor the portfolio throughout its fixed term, helping to avoid default risk and maximise the yield.
We believe that with the peak in the interest rate cycle near at hand, today represents an opportunity to lock in attractive yields and a fixed maturity bond fund offers a straightforward vehicle to achieve this.
1Source: Morgan Stanley, Morgan Stanley Financial Conditions Index, 20 October 2023.
2Source: Bloomberg, World Interest Rate Projections, as at 23 October 2023.
Credit ratings: A score given by a credit rating agency such as S&P Global Ratings, Moody’s and Fitch on the creditworthiness of a borrower.
Credit risk: The risk that a borrower will default on its contractual obligations, by failing to meet the required debt payments.
Corporate bonds: A debt security issued by a company. Bonds offer a return to investors in the form of periodic payments and the eventual return of the original money invested at issue on the maturity date.
Default: The failure of a debtor (such as a bond issuer) to pay interest or to return an original amount loaned when due.
Diversification: A way of spreading risk by mixing different types of assets/asset classes in a portfolio. It is based on the assumption that the prices of the different assets will behave differently in a given scenario. Assets with low correlation should provide the most diversification.
Duration: The sensitivity of a bond or fixed income portfolio to changes in interest rates. The larger the figure the more sensitive it is to movements in interest rates.
Financial conditions: A mix of conditions that have the potential to affect the economy, covering aspects such as cost of borrowing, the direction of asset prices, and currency strength. Tighter conditions are said to exist when borrowing costs rise, equity prices fall and the US dollar strengthens, which are seen as headwinds to growth.
Fiscal policy: Connected with government taxes, debts and spending. Government policy relating to setting tax rates and spending levels. It is separate from monetary policy, which is typically set by a central bank. Fiscal austerity refers to raising taxes and/or cutting spending in an attempt to reduce government debt. Fiscal expansion (or ‘stimulus’) refers to an increase in government spending and/or a reduction in taxes.
Inflation: The annual rate of change in prices, typically expressed as a percentage rate. The Consumer Price Index (CPI) is a measure of the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services. Disinflation is a decline in the rate of inflation.
Interest rate cycle: Interest rates typically rise and fall over time and a full cycle reflects the change from trough to peak and back again. The movement in rates is typically affected by how central banks respond to growth and inflation in the economy.
Investment grade: A bond typically issued by governments or companies perceived to have a relatively low risk of defaulting on their payments. The higher quality of these bonds is reflected in their higher credit ratings.
Maturity: This refers to the date when a bond’s principal (original value) is repaid to the bondholder. The term to maturity is the period in which a bondholder receives interest payments.
Monetary policy: The policies of a central bank, aimed at influencing the level of inflation and growth in an economy. It includes controlling interest rates and the supply of money. Easing refers to a central bank increasing the supply of money and lowering borrowing costs. Tightening refers to central bank activity aimed at curbing inflation and slowing down growth in the economy by raising interest rates and reducing the supply of money. Restrictive policy is where policy is being tightened.
Recession: A significant decline in economic activity lasting longer than a few months. A soft landing is a slowdown in economic growth that avoids a recession. A hard landing is a deep recession.
Speculative grade: A bond with a lower credit rating than an investment grade bond, also known as a sub-investment grade bond, or high yield bond. These bonds usually carry a higher risk of the issuer defaulting on their payments, so they are typically issued with a higher interest rate (coupon) to help compensate for the additional risk.
Treasury: a debt security issued by the US government. A Treasury Bill is for 12 months or less, while a Treasury Bond is for longer.
Volatility: The rate and extent at which the price of a portfolio, security or index, moves up and down.
Yield: The level of income on a security, typically expressed as a percentage rate. The 10-year Treasury yield is the interest rate on US Treasury bonds that will mature 10 years from the date of purchase.