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It is time to embrace the potential for higher interest rates and put the “Income” back into Fixed Income.

Traditionally, investors have been able to count on bonds as a primary source of income.  However, with interest rates beginning 2021 near historic lows and spreads near the tighter end of their range, the set-up for fixed income coming into this year was not particularly attractive.  From a macro perspective, we were forecasting an improving growth outlook, an accommodative Fed, the potential for additional fiscal stimulus, and the rollout of a vaccine distribution program.  All this led us to the conclusion that the macro environment was getting better and that interest rates should move higher, which ultimately meant that fixed income return expectations should be tempered.

At the beginning of the year, the Bloomberg Barclays Aggregate index was yielding a little over 1%.  In comparison, a shorter duration index such as the Bloomberg Barclays 1-3yr Govt/Credit index was yielding 0.23%.  With yields this low across the maturity spectrum, we were reminding clients that fixed income was not living up to its name as there was very little income left in fixed income.

Fast forwarding to today, we have seen interest rates move higher, the yield curve steepen, and credit spreads move tighter.  Unfortunately, this price action has resulted in negative total returns across many fixed income products.  Longer duration strategies have been negatively impacted the most this year, while shorter duration strategies have held up better, but have also struggled to achieve positive total returns.

The increase in interest rates has caused some unwelcomed short-term pain for fixed income investors.  However, it is important to remember recent history and the strong fixed income returns realized over the past couple of years.  In 2019, the Bloomberg Barclays Aggregate Bond Index returned 8.72%.  This performance was followed up with another strong year in 2020 and a 7.51% return.  These outsized returns should not be discounted and could easily be viewed as investment returns that were borrowed from the future.

While this thought process is fine from the long-term investor perspective, new fixed income investors may have a different opinion.  An important investment concept to consider is the timeframe in which a fixed income investor begins investing in bonds, and the yields the market offers at the time of the initial investment.  In today’s environment, yields are low and credit spreads are tight, which can have important implications on an investor’s long-term total return potential. 

Many fixed income investors, especially those who rely on income for living expenses, would prefer to see interest rates rise.  However, the downside to a rise in interest rates is a decline in bond prices.  While this may cause some temporary angst among investors, a higher level of interest rates is not necessarily a bad thing.  Higher rates will offer fixed income investors the potential for obtaining a greater amount of income from their investments and a brighter return profile going forward.  So, if you are hoping for interest rates to move higher, please take comfort in knowing that you are not alone, as the quest for yield and stable cash flow generating opportunities currently remains a challenge.  Rather than continuing to move down the risk spectrum to reach for yield, there is a growing fan base of investors who would ultimately like to see interest rates move higher and the “income” be put back into fixed income.

 



 

The views expressed herein are presented for informational purposes only and are not intended as a recommendation to invest in any particular asset class or security or as a promise of future performance.  The information, opinions, and views contained herein are current only as of the date hereof and are subject to change at any time without prior notice.

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