A few thoughts on fixed income

J.P. Morgan Asset Management
Tai Hui
Tai Hui
Chief Market Strategist, Asia Pacific
Instead of trying to time the market, the role of government bonds is to provide downside protection if economic momentum slows more than expected.

Thinking beyond the peak of bond yields

In our June FOMC webinar, many clients are interested in whether U.S. government bond yields would peak soon. This is important to manage duration risks as investors look to increase allocation in fixed income assets, given the prospects of economic deceleration in the U.S. While this is a reasonable question, this should not be the only consideration when investing in fixed income.

The U.S. rate hiking cycle by the Federal Reserve (Fed) typically lead to a convergence of policy rate and U.S. Treasury (UST) yield, or a flattening of the curve. This is because that investors would expect tighter monetary policy to slow down economic growth. This implies that 10-year yield should be rising at a slower pace than policy rate once the hiking cycle is underway. The peaking of inflation in the coming months would also be helpful to contain the rise in the long-term bond yields.

It is also important to understand that the current level of UST yield provides more ample buffers against duration risks than earlier in the year. With a 10-year U.S. government bond of a duration around 8 years, and yield to maturity at 3.3%, bond yield would need to rise by 41 basis points (bps) for the drop in bond price to wipe out the annual interest payment. This compares with just 20bps at the start of the year.

Moreover, if the U.S. economy is indeed moderating in the coming quarters, UST bond yields are expected to eventually decline, even if it rises in the near term in response to the Fed’s policy tightening. Admittedly, investors may be able to invest in government bonds at a lower price. Instead of trying to time the market, the role of government bonds is to provide downside protection if economic momentum slows more than expected. Overall, we suggest investors to focus more on the diversification benefits from fixed income, instead of trying to time the market and pick the peak in UST yields. 

Exhibit 1: Yields and correlations of fixed income returns to equities

Source: Barclays, Bloomberg Finance L.P., FactSet, ICE BofA Merrill Lynch, J.P. Morgan Economics Research, MSCI, J.P. Morgan Asset Management.
Based on Bloomberg Barclays U.S. Treasury (UST) Bellwether 2y & 10y (2y & 10y UST), Bloomberg Barclays Treasury Inflation-Protected Securities (TIPS), ICE BofAML Country Government (1-10y) (France, Germany, Japan & UK (1-10y)), Bloomberg Barclays U.S. Aggregate, Credit – Investment Grade & High Yield (U.S. Aggregate, IG & HY), Bloomberg Barclays U.S. Floating Rate (U.S. Floating Rate), Bloomberg Barclays U.S. Aggregate Securitized – Mortgage-Backed Securities (U.S. MBS), Bloomberg Barclays Pan-European High Yield (Europe HY), J.P. Morgan GBI-EM Global (Local EMD), J.P. Morgan EMBI Global (USD EMD), J.P. Morgan Asia Credit (JACI) (USD Asia Credit), J.P. Morgan Asia Credit (JACI) – High Yield (USD Asia HY), J.P. Morgan Asia Credit China Index (USD China offshore credit), J.P. Morgan CEMBI (USD EMD corporates), J.P. Morgan Asia Diversified (JADE) (Local Asia). *Correlations are based on 10-years of monthly returns.
Guide to the Markets – Asia. Data reflect most recently available as of 31/03/22.

Choosing between investment grade vs high yield

The choice between different qualities of corporate credit does depend on our view of the U.S. economy and how they fit into overall portfolio construction. The latest economic data are still pointing towards subdued recession risk in the U.S., especially taking into account the robust job market. This would point towards a more constructive outlook for high yield (HY) corporate bonds with low default rate and stronger income stream from coupons. Elevated oil prices would also support the energy sector, a heavyweight in the U.S. HY bond market and historically more prone to rising default during periods of oil price volatility. The HY bond market is also helped by undemanding maturity profile in 2022 and 2023. The current HY credit spreads, at 550bps, are above its 10-year average.

The investment grade (IG) corporate bonds would arguably better suited for investors that are more concerned about economic slowdown, or even recession. On June 22, Fed Chairman Jerome Powell did warn in his Senate Banking Committee hearing that a recession is a possibility. As we discussed, a slowdown in the U.S. economy would prompt UST yields to decline, boosting bond prices. Since most investors are not going to completely sell down their equity allocation, nor should they, IG corporate debt could provide more diversification benefits for the overall portfolio construction than HY bonds. 

Investment implications

We can deconstruct corporate bond return into three components, the change in risk-free rates, the change in corporate credit spread, and coupon yield. In a stable growth environment, HY is likely to generate better overall return with potential for some credit spread compression contributing to bond price return, adding to attractive coupon yields. This also applies for investors who are less sensitive to mark to market volatility and are able to invest through the economic cycle.

However, when economic growth slows down and investors believe corporate default could be more common, corporate credit spread for all corporate bonds would widen. This impact on HY bonds to bond price could be severer than IG. Moreover, the prospects of weaker growth would push risk-free rates lower, this could offset some of the negative impacts from wider credit spread. Our research shows that IG corporate credits have a strong advantage here.

Moreover, as shown in Exhibit 1, IG bonds have a lower correlation with equities, this also gives IG an edge over HY as a component of portfolio construction when preparing for weaker economic growth in the U.S. 

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(1) Source: J.P. Morgan Asset Management. Data as of 31.3.2021. (2) Diversification does not guarantee investment returns and does not eliminate the risk of loss. (3) Source: J.P. Morgan Asset Management. Data as of July 2020. We report annually and are audited.