Fixed Income Portfolios: Helping clients navigate volatility, inflation and rising rates
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Text on screen: PIMCO EDUCATION, Fixed Income Portfolios: Helping clients navigate volatility, inflation and rising rates with Roger Nieves (10 minutes)
Text on screen: PIMCO provides services to qualified institutions, financial intermediaries and institutional investors. This is not an offer to any person in any jurisdiction where unlawful or unauthorized.
Text on screen: Roger Nieves, Senior Advisor, PIMCO Education Team
Nieves: Hi everyone. Welcome to helping investors navigate volatility, inflation and rising rates in bond portfolios. This is indeed one of the toughest bond market environments that we have seen in years. There is a however, a potential silver lining to the cloud that we have experienced, and we are going to talk about that today.
Text on screen: TITLE – Agenda
Image on screen: Two boxes side-by-side display the agenda: fundamentals and client questions.
We are also going to address a couple of frequently asked questions.
But first let’s start with a few fundamental concepts.
And in many respects, a bond is simply a loan. Governments borrow money in the bond market to build bridges and tunnels.
Companies borrow money in the bond market to invest in people and equipment.
Text on screen: TITLE – What is a bond (or note)? SUBTITLE – Example: Two-year note (yield-to-maturity 2%) with semi-annual coupons
Image on screen: A diagram shows the path to maturity of a two-year note with semi-annual coupons. A solid, horizontal arrow labeled “maturity” runs through the middle of the diagram and represents the passage of the two-year period. The arrow points to the far right side of the diagram.” On the far left, a red bar below the arrow shows a price of the two-year Treasury of $100. Above the arrow, four coupons of $1 each in succession mark the passage of time under Year One. On the far right, a blue bar represents $100 in principal, under Year Two. The diagram also notes that yield-to-maturity is the estimated rate of return for a bond, assuming an investor holds it until its maturity date.
Here you see a simple illustration of a two year note that one of these entities might use to borrow money.
The price is $100. This note pays out two semi-annual coupons of $1 each year. Yield to maturity, which is an estimation of future return, is calculated to be 2%.
How is it that this simple security can cause so much heartburn in the markets this year?
Well the short answer is that like the price of a stock or a piece of real estate, the price of a bond can move up and down – and that has surprised some investors.
Let’s walk through an example to see how that works.
Text on screen: TITLE – What happens to the price of this note as interest rates move?
Image on screen: A table shows what happens to a two-year note as interest rates change, in terms of yield and price. In the first row, the yield is 2% and price $100. The second row shows that if interest rates were to fall to 1%, the price of the note would rise to $101.97, with investors willing to pay a premium for $100 of principal. Yet if rates were to increase to 4.6%, the price of the bond would fall to $95.13 in order to discount the note enough to entice investors to buy it.
Let’s say, that after I buy that two year note that we just saw at par for $100, interest rates fall to 1% as shown here in green, am I happy? You bet! I have a note in my possession that pays a 2% yield when comparable notes now pay only a 1% yield. I am quite happy.
In fact, other bond investors would likely pay me a premium for that juicy two percent yield if I went to go out and sell it. Here we see that they are willing to pay me $101.97.
If on the other hand, I buy my two year note and then I see that the yield on comparable notes moves up to say 4.6%, I am now quite sad. My 2% note is now yesterday’s seafood special. Investors would only pay me $95.13 if I went out to sell it.
It is this relationship between bond prices and yields that underlies the seesaw concept that many of you may be familiar with.
Text on screen: TITLE – Bond prices are inversely related to interest rates; SUBTITLE – As yields move up and down, bond prices move up and down.
Image on screen: A diagram shows a scale—much like a seesaw—show how bond prices are inversely relate to interest rates. The scale is out of balance. On the left-hand side, which tips upward, a circle is labeled “Rates Rise,” with an upward pointing arrow. The other side of the scale, labeled “Prices Fall,” tips downward, showing falling bond prices.
If interest rates move up, bond prices move down and vice versa. If interest rates move down, bond prices generally move up.
And indeed, as interest rates have moved up in recent months, you have seen this teeter totter relationship play out in bonds and bond fund values.
But the other important thing to remember as you review your monthly statements however is that there are two components of return to your bond investments.
Text on screen: TITLE – Total return in bonds
Image on screen: A diagram shows an equation of how the change in bond price, plus the coupon income, equals total return.
First, the price return – and prices can change in a given day or week as we just saw.
But second, and arguably more important for many types of bonds is the coupon return.
Over the last several decades, over 90% of the total return in a commonly referenced benchmark for the US bond market has come from interest payments and the reinvestment of interest payments.
OK we’ve covered some important concepts, but let’s get more specific.
Text on screen: Question #1. In 2022, we’ve seen the worst start to a year for bonds in decades. What is going on?
In 2022, we’ve seen one of the toughest starts to a year for bonds in decades. What is going on?
Well in a word inflation. Many of us see inflation every day when we fill up at the gas pump or when we visit the grocery store.
There are a number of factors driving inflation.
Text on screen: TITLE – In a word, inflation; SUBTITLE – Components of the CPI basket
Image on screen: A pie chart shows components of the CPI basket, broken into nine slices. Housing ex-energy is the largest component, followed by roughly equal sections of food and beverages and transportation ex-energy. Energy is next, followed by roughly similar slices from recreation, education and communication, and medical care. Apparel and other goods and services make up the other two slices. The chart also shows external factors that point towards the pie: commodity prices, rent and lodging prices, wage and policy influence, and import prices.
The tragic events in Ukraine have impacted grain, oil, and other commodities.
COVID related supply disruptions have impacted manufacturing
Inflation is now a challenge across the financial markets.
In bonds, inflation erodes the purchasing power of the coupon and principal payments that you expect to receive far into the future.
Text on screen: TITLE – The Federal Reserve targets price stability and full employment; SUBTITLE – Inside the Fed’s Toolkit
Image on screen: A diagram shows a picture of a Federal Reserve building on the left, and a list of the Fed’s toolkit on the right. The items in the toolkit include: raising or lowering interest rates, buying or selling government bonds, and forward guidance.
The Federal Reserve sets the target for US short term interest rates.
The Fed has a dual mandate. The Fed seeks to foster both full employment and price stability.
The job market is strong these days, but on the other hand, the Fed is keenly aware of the steady pain that consumers are feeling from inflation.
Consequently, that price stability mandate is taking priority in their decision making.
Financial markets are now bracing for a series of rate hikes, as the Fed seeks to tamp down on inflation, and that is what is driving yields higher in the bond market.
Text on screen: TITLE – Two year and five year yields have increased in anticipation of Fed rate hikes
Image on screen: A line graph shows the Fed Funds Rate and the two and five-year U.S. Treasury yields from March 2015 to March 2022. The Fed Funds rate lags the Treasury yields over the period. In 2021, the two and five-year yields start rising sharply upwards, reaching a peak on the graph by March 2022. The five-year climbs to around 2.5%, up from 0.75% in September 2021, while the two-year rises to about 2.4%, up from 0.2% over the same period. The levels reached this year are similar to a peak last seen in the fall of 2018, with the graph showing the five-year reaching about 3.1% and the two-year, 2.9%. Rates had been rising at that time for roughly two years, with the Fed Funds rate lagging. The Fed Funds Rate didn’t peak until a few months after the Treasuries, at about 2.5%, up from a bottom of 0.25% in 2015. In March 2022, the Fed Funds rate is shown to be about 0.50%, showing a big gap below the Treasury yields at that time.
Historically, short maturity yields – and here we are graphing the yield on a two year treasury note – have moved in rhythm with the Fed Funds target.
But what is really remarkable is how in 2022, the bond market has sort of done the Fed’s job for them. They have really ripped the band aid off. Yields have increased quickly in anticipation of rate hikes.
And this gets to the heart of our discussion today.
On the one hand, this move up in yields creates price movement as we saw earlier.
But on the other hand, this cloud has a silver lining. The move in yields improves return prospects for investors over the medium term.
Text on screen: Question #2. Should I allocate to bonds at all?
OK, let’s tackle a question that some are asking these days, and that is “should I allocate to bonds at all?”
Each investor if different, but bonds can be beneficial for many types of investors. Bonds play three roles in a portfolio:
Text on screen: TITLE – Fixed income allocations may offer multiple benefits to a portfolio
Image on screen: A circle showing the three potential benefits of fixed income allocations is made up of arrows, pointing in a clockwise dimension. The three benefits are as follows: Capital preservation, in blue, income and total return, in green, and equity diversification, in red.
One, defense. They help to preserve principal.
Two, bonds generate income.
And, bonds help to diversify equity and other risk investments. Bonds tend to zig when other markets zag
Bonds have important capital preservation characteristics. US government bonds are backed by the full faith and credit of the US government.
Text on screen: TITLE – Corporate capital structure
Image on screen: A pyramid shows the corporate capital structure, organized in tiers, from the most secure instruments up top, to the equity components at the bottom. Senior secured bonds are at the tip of the pyramid, followed by layers underneath it: senior unsecured bonds, convertible and subordinated debt, and preferred stock. Common stock follows after that, at the very bottom of the pyramid.
Corporate bonds, as you can see in this picture, also have legal and structural benefits. In the event of a stress event for example, senior bondholder claims tend to be paid before those of other investors in a corporation.
Sometimes bondholders have claims on specific hard assets like real estate or airplanes.
And it is so important to remember the power of interest income as we mentioned earlier.
In fact, historically, the correlation between starting yield and subsequent 5 year returns for say high quality US core bonds has been 94%.
Text on screen: TITLE – Starting yields across asset classes look more attractive after the recent repricing of the yield curve; SUBTITLE – Today yields are at a much stronger starting point
Image on screen: A bar chart shows yield to worst for nine different fixed income classes as of 30 April 2022. On the left, in blue, two bars show core and agency MBS, both at 3.5%, the shortest on the chart. In the middle, green bars show the following: investment-grade credit, at 4.2%, U.S. preferreds, at 5.5%, high-yield credit at 6.5%, and bank loans at 6.5%. Next, emerging market yield, in red, is at 6.3%. On the far right, in light blue, are municipal bonds, at 5.3% and high-yield munis, at 7.9%. Underneath the bar graph, a table shows year-to-date change in increase in yields, ranging from 177 basis points for core bonds, to 353 basis points for munis.
This chart here shows you the yield on a number of key segments of the bond market including core US bonds and corporate bonds.
Look at how these yields, shown here as of the end of April 2022, have now reached levels that are much more attractive than those that we encountered in 2020 or 2021.
You can now earn 3.5% yields in core bonds, 4% yields in corporate bonds and 6.5% yields in high yield bonds. Value in the municipal bond market has also improved. You can now earn a 3.1% yield in the muni market which translates into an over 5% yield when you factor in potential tax advantages.
And as we saw earlier when we looked at the Two-year treasury, short maturity yields in particular have edged up.
Text on screen: TITLE – Short term bonds may provide attractive yields and diversification benefits
Image on screen: A rough graph of potential return versus risk for four different fixed income asset classes, represented by rising boxes from left to right. The boxes represent various tiers of return and risk for money market funds, ultrashort duration, short-term, and intermediate core fixed income. Potential return is shown on the Y-axis and potential risk on the X-axis. For Tier 1 money market, a box on the bottom left of the graph, represents funds with duration of several weeks to months. Tier 1 has the lowest potential return and lowest potential risk. Slightly higher and to the right is Tier 2, representing bonds with ultra-short terms of three to 12 months, showing higher return and risk versus money market funds. Even higher and to the right of Tier 2 is Tier 3, representing bond portfolios of more than 12 months in duration. Next is intermediate core fixed, in the top right of the graph, with the highest potential return and risk for the four strategies shown. An arrow points from this box downward and to the left, back to Tier 3, which represents a middle ground, where the aim is to harvest incremental return beyond money markets for a slight increase in risk, potentially reducing market risk and interest rate sensitivity.
These days you can earn attractive yields by investing in short duration or low duration bonds.
With short term or low duration bond funds, you do take on some modestly higher volatility or credit risk, but the yields available in this space are higher than those available to investors in bank savings or money market funds, which may not have yet priced in Fed rate hikes to the same degree.
This a potential sweet spot for investors that are looking for an attractive tradeoff between yield and risk.
Text on screen: TITLE – Summary & Key Takeaways
Image on screen: A diagram lists a summary and key takeaways, shown in three boxes. Up top, the first box notes this is a challenging environment for bond investors. Beneath, a second box makes the point that income is a key driver of total returns in bonds, and that long-term in core bond portfolios correlate to starting yield. The third box on the bottom notes that an allocation to fixed income has historically provided income, capital preservation, and diversification benefits.
To sum up, this is a challenging environment for bond investors.
We saw however how income is such a key driver of long term total returns in bonds. And in that regard, today’s higher yields should really help.
An allocation to bonds has historically provided investors of all stripes with income, capital preservation, and diversification benefits.
Thank you for your time. For additional information, please visit us at pimco.com
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Disclosure
All investments contain risk and may lose value. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, call risk, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and low interest rate environments increase this risk. Reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Sovereign securities are generally backed by the issuing government. Obligations of U.S. government agencies and authorities are supported by varying degrees, but are generally not backed by the full faith of the U.S. government. Portfolios that invest in such securities are not guaranteed and will fluctuate in value. High-yield, lower-rated, securities involve greater risk than higher-rated securities; portfolios that invest in them may be subject to greater levels of credit and liquidity risk than portfolios that do not. Income from municipal bonds for U.S. domiciled investors is exempt from federal income tax and may be subject to state and local taxes and at times the alternative minimum tax.
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