The Big Mac on fixed income valuation

September 22, 2022 10:28
Source: Bloomberg, MFS

Entry points are not just for tactical investors. It is usually assumed that only tactical investors pay close attention to market entry levels. But we would argue that in fixed income investing, entry points strongly influence longer-term expected returns as starting yields and future returns are typically related in most fixed income asset classes. This is a function of how fixed income total returns are generated, with income typically being their most significant and stable component over time.

Current yields may be attractive by historical standards. Fixed income yields are trading near their highest levels over the past ten years, with all major sub-groups above the 90th percentile (Exhibit 1). This has been the result of the recent rate correction combined with major spread widening. The rise in yields since the beginning of the year has been significant across the fixed income universe, where yields in the high-yield space have risen by over 400 basis points, emerging market sovereign debt yields have picked up by about 350 bps and investment-grade yields have increased by about 235 to 245 bps, depending on the region (Exhibit 2).

Historically, starting yields have tended to influence future returns. Historical data suggest a relationship between entry yields and subsequent returns. In US investment-grade corporate credit, for instance, the current yield stands at 4.69%. In historical periods when the starting yield was between 4.5% and 4.8%, subsequent 5-year returns ranged between 0.3% and 6.5%, with a median return of 4.6%. When analyzing historical market conditions, we found that the lower-outlier returns could be explained by a sharp upward correction in US rates that took place over the next few years, which, notably, was the case in 2003 and in 2017. Looking ahead, significant increases in US rates are now unlikely, we believe, especially with the risk of recession more on investors’ minds.

Global aggregate yields could potentially be attractive from a valuation standpoint. Similarly, there appears to be a relationship between starting yields and future returns for the Global Aggregate Index. With yields today at 2.9%, we analyzed historical periods in which the starting yield ranged between 2.8% to 3.1% and found subsequent 5-year returns varied between 2.9% to 4.9%, with a median of 4.5%.

Emerging market sovereign debt yields could potentially represent attractive entry levels for strategic investors. Running the same kind of analysis for emerging market sovereign debt, where yields are currently at 8.8%, we found that in historical periods when the starting yield was between 8.5% and 9.0%, subsequent 5-year returns ranged between 3.4% and 10.8%, with a median return of 7.2%.

A significant valuation cushion has been rebuilt after the yield correction in global fixed income. This is best illustrated by looking at total return breakeven yields, which show how much yields would have to rise before one year of coupon income is offset and the resulting total return is zero. The higher the breakeven yield, the lower the probability of realizing a total return equal to zero, and the better the cushion an investor has against rising rates. Breakeven yields have virtually doubled across most asset classes since the beginning of the year. That valuation cushion is particularly significant for both US high yield and European high yield, which would have to experience a yield increase of over 200 bps in current levels to produce zero returns over the next year.

Stress testing the strategic power of fixed income investing. Another way to illustrate the potentially attractive valuation of fixed income over the long term is to stress test the impact of a one-time 50 bps increase in US Treasury rates on a US IG corporate credit portfolio, using the Bloomberg US Aggregate Corporate Index. The results of our stress test process show that, after an initial loss due to the initial rate shock, simulated returns would recover over time and ultimately reach an annualized 4.5% simulated return after ten years as higher reinvestment rates offset the initial loss over time. This suggests that the simulated 10-year annualized returns will be broadly in line with the starting yield, further supporting the case that starting yield may be a strong determinant of longer-term returns and highlighting income’s role as a long-term driver of fixed income total returns.

We believe that the valuation backdrop for fixed income may be compelling, especially for investors with a longer-term time horizon. Over the past decade, low fixed income yields have turned off investors, and some have reduced their allocations to the asset class as they search for higher-yielding (and potentially higher risk) assets. Given its poor performance over the past few quarters, it is no surprise that fixed income has fallen out of favor. However, the recent rise in yields and spreads has significantly changed the dynamics and led to a substantial improvement in the valuation backdrop. We therefore encourage strategic investors to re-look into their fixed income allocations.

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Source: Bloomberg, MFS

Director, Investment Solutions Group, MFS

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