Optimize Income With Short-term Core and Credit
As monetary policy uncertainty continues to stoke rate volatility, look for strategies with lower rate risks than broad core bonds. Meanwhile, a growing economy, fundamental growth and positive ratings trends support taking on credit risk — even with spreads as tight as they are.
Uncertainty over Federal Reserve (Fed) policy has led to record-breaking rate volatility for core aggregate bonds. And, the resulting losses have added to core bonds’ double-digit two-year drawdown.1 Given the Fed’s reliance on data, and with key economic data coming in with more variability relative to expectations, it’s likely that increased market volatility will continue.
But credit isn’t witnessing the same volatility. Foundations for its year-to-date gains are underpinned by sturdy economic growth, improving earnings fundamentals, and positive ratings momentum. Spreads, however, are noticeably tight. And while that can be cause for concern, historically, at these current levels, returns have still been positive over the following 12 months.2
Given that the outlook for credit is favorable while broad core bond exposures are challenged by policy-related rate volatility, investors should consider:
- Actively managed floating rate loan strategies that seek to limit rate volatility without sacrificing income potential by focusing on high-yielding below investment-grade markets
- Short-term active core strategies to pursue more yield with less volatility than core bonds, by balancing exposure to rate- and credit-sensitive sectors
- Balanced high-quality intermediate investment grade bonds to take on more fairly-compensated credit and rate risks, given their yield, duration, and spread profiles relative to core bonds
Fed’s Policy Patience Delays Rate Cuts
After significant declines in 2023, CPI has since made limited progress toward the Fed’s 2% target. As a result, the Fed anticipates keeping rates elevated for longer than previously expected, until more progress is made to temper stubborn inflation.3 This should keep short-term rates, like the US 2-year yield, close to the fed funds rate, limiting the slope of the curve. In fact, consensus economic forecasts have the differential between the US 2- and 10-year remaining inverted until Q1 2025, with the 3-month and 10-year differential not having an upward slope until at least Q3 2025.4
Futures implied forecasts show the market slowly warming to the idea of higher for a little bit longer. At the start of the year, implied futures pricing projected the lower bound of fed funds rate to be 4.35% by July whereas current projections expect it to be 5.25% (indicating no cuts by July).5 The same trend exists for the year-end rate level. To start the year, futures markets had the fed funds rate at 3.75% while current projections have the average rate at 4.8%.6
Big picture? The curve will likely remain inverted for a bit longer, as long as short-term rates remain high. But some rate cuts may occur in the second half of this year — just not as many as previously expected. There’s also a slight risk of no rate cuts this year, as some Fed officials have warned against not finishing the job on cooling inflation.7
Analysis from Strategas Research Partners reinforces this risk. They found that multiple waves of inflation are common — with a second wave of US inflation starting on average 30 months after the first peak. The US is now almost 24 months past the June 2022 peak in CPI.8
New Challenges Cloud Rate Risks
The data-dependent Fed is challenged by the increased variability of key economic data releases. This variability likely stems from changes in consumption, employment, and social behaviors during the pandemic that have made accurate economic data forecasts more difficult.
For example, CPI prints this year have deviated from consensus expectations by an average of 10 basis points (bps). It’s the fourth consecutive year where prints have deviated by more than the pre-pandemic 10-year average of 7 bps.9 The same trend exists with labor reports; data this year is coming in over/under estimates by a wider range than normal (~50% deviation from expected versus pre-pandemic average of 31%).10
The calendar also will challenge the Fed’s ability to remain patient. The window to implement policy decisions prior to a systemic macro event like the US election closes a little more each day. And as data continues to exhibit higher variability than normal, rate volatility will have more reason to remain elevated — challenging rate-sensitive bond allocations.
These challenges are underscored by the fact that long-term US Treasury bonds’ rolling 90-day standard deviations of returns (13%) are greater than US equities’ (12%).11 Typically, perceived safe-haven long-term US Treasurys have a realized volatility that is four percentage points less than stocks.12 Not so in this new rate risk regime.
Core bonds are experiencing a similar trend. While not greater than stocks, their own standard deviation of returns over the past 90 days plots in the historical 89th percentile over the past 30 years.13 In fact, this latest bout of realized rate risks has exacerbated the longer trend, as the Bloomberg U.S. Aggregate Bond Index’s (Agg) trailing 3-year standard deviation of returns is at all-time highs (Figure 1).
Credit Outlook More Favorable
The same healthy economic signs that led to rate cut repricing have helped support credit exposures. In fact, five tailwinds underpin the case for credit:
- A growing economy: A healthy labor market, resilient household demand, and business investment fueled a 3.1% real rise in final sales to private domestic purchasers. This key gauge of underlying demand has expanded for three consecutive quarters.14
- Positive earnings growth: After a string of negative quarters, earnings for US equities are poised to record their third consecutive quarter of growth.15 Earnings growth is projected for the two remaining quarters of 2024 and for all of 2025.16 For below investment-grade issuers, the same trends exist as positive Q1 earnings surprised to the upside.17
- Improving ratings momentum: After downgrades outpaced upgrades for seven consecutive quarters, the upgrade-to-downgrade ratio finally moved above 1 (indicating more upgrades than downgrades) in Q2. Positive ratings momentum indicates improving overall credit fundamentals, a trend also reflected in improving debt coverage ratios for below investment-grade issuers (Figure 2).18
- A healthy coupon (i.e., carry): High yield bonds yield around 8%, while senior loans have a yield above 9%19 — greater than their own historical averages and the yields of today’s core bonds.20
- Supportive technicals: High-yield issuers have brought $113 billion of new issuance to the market, almost twice the pace of this time last year.21 And in April, more than 40 US investment-grade firms sold $53 billion of bonds over a three-day stretch, the most crowded three-day calendar since 2021, while high-yield issuers priced nearly $11 billion — seizing on strong investor demand for the carry associated with credit.22
Tight credit spreads are cause for concern. For both high-yield and investment-grade corporate bonds, spreads are approximately 40% below their historical averages and plotting in the lowest quintile over the past 20 years.23 Yet, our research shows that the relationship between the starting spread level and the subsequent 12-month returns is mixed.
Rather than a linear relationship, where the lowest returns occur when spreads are in the bottom quintile and the best returns when spreads are in the top quintile, returns show more of a “smile” pattern (Figure 3). In fact, quintile one’s (today’s) starting spread level returns are higher than quintiles two or three for investment-grade corporates and high yield.
Optimizing Income Opportunities While Managing Rate Risks
Elevated rate risks and conducive credit trends support using credit-related strategies that have the potential to limit rate-induced price swings. Expressing a bias to credit can take many forms, however.
Figure 4 illustrates the yield, duration, volatility, and yield-per-unit-of-volatility ratio profiles of short-term bond sectors to help you decide how to pursue today’s credit opportunities in an evolving rate risk regime.
The flexibility of active strategies to manage rate risks, while pursuing opportunities amid a broader universe, may be the most beneficial approach in the core. More so, duration-controlled active strategies that combine both traditional bond sectors (e.g., investment-grade corporates and US Treasurys) and non-traditional ones (e.g., CLOs, securitized credits) can support tactical positioning along the yield and credit curve.
An actively managed senior loan strategy can also help limit rate risks, without sacrificing income. Due to their floating rate coupons, senior loans have minimal interest rate risk — resulting in realized volatility of just 2.2%, versus the Agg’s 7.6% over the past year.24
Since senior loans are below investment-grade rated securities, this reduction in rate risk doesn’t constrain their potential for income generation. Yields are above 9%, leading to a yield-per-unit-of-duration more than four times that of core bonds and three times that of fixed-rate high yield (Figure 4). And active strategies’ prudent risk management and sector and security selection may help navigate a credit market with healthy fundamentals and supportive technicals, but rich valuations.
Balanced credit strategies can also be found within investment-grade markets. High-quality investment-grade corporate bonds with maturities between 1 and 10 years, leading to a weighted duration of four years, allow investors to take on some duration risk, but with a better balance toward income. The segment’s 5.41% is greater than core bonds’ 5.07% and on par with broad corporates’ 5.60%.25
Sitting in the short-plus belly of the curve cuts out the long-term tail of corporate bond exposures that offer little yield pickup (30 bps) while adding eight years of duration relative to the 1-10 year space.26 As a result, the 1-10 year part of the corporate curve helps strike a better balance between yield, duration, and potential rate volatility relative to other broad corporate bond and Treasury sectors.
Implementation Ideas
To protect against rate volatility and also take on credit risk in response to positive economic trends, consider:
