Preparing for the Pivot: Advisor Fixed Income Portfolios After 2022’s Historic Rise in Rates
Summary
- Higher yields and a potential end to Fed rate hikes suggest it may be time for advisors to reevaluate fixed income portfolios.
- The performance of fixed income sectors in 2022 was among the worst since World War II, but the outlook for fixed income now looks brighter.
- Analysis of past hiking cycles shows that now may be a good time to move cash off the sidelines despite recent volatility.
- Diversifying credit allocations may help improve risk-adjusted returns amid elevated recession risks.
Last year’s sell-off in fixed income has led to attractive yields at the front end of the yield curve, offering investors a place to wait out uncertainty in financial markets. But the question on most advisors’ minds is when to get back in to longer-term investments and how?
The performance of nearly all fixed income sectors in 2022 was among the worst since World War II. Amid aggressive Federal Reserve efforts to tame inflation, interest-rate-sensitive core fixed income, credit and equities all sold off, offering few places for investors to avoid losses.
Yet the outlook for fixed income now looks much brighter, in our view. Higher yields have meaningfully increased return expectations and may provide a stronger cushion against further increases in interest rates or spread widening. However, an inverted yield curve, elevated inflation, and recession fears make duration and credit positioning a challenge.
Our 8th annual review of advisor fixed income portfolios is based on an analysis of the nearly 2,800 portfolios we reviewed on behalf of advisors in 2022 to address investment considerations for the road ahead. Key themes include:
- Analysis of past hiking cycles shows that now may be a good time to consider moving cash off the sidelines despite recent volatility.
- Higher starting yields may help insulate portfolios from the effects of further rate hikes, while potentially helping core bonds outperform cash.
- Diversifying credit allocations may help improve risk-adjusted returns amid elevated recession risks.
Bonds are back
Starting yields across most fixed income sectors are at their highest levels in more than a decade following interest rate hikes in 2022. As we highlighted last year, future returns for bonds have historically followed starting yields in both duration- and credit-sensitive sectors. Figure 1 shows that the yield of the average advisor portfolio more than doubled in 2022, to 5.8% from 2.3%. According to PIMCO’s five- year annualized capital market assumptions, fixed income’s potential to drive returns in diversified portfolios is as compelling as it has been in over a decade.
Yet rising yields have not been easy for investors. The Bloomberg US Aggregate Bond Index, which has had positive returns in 42 of the past 47 years, fell for a second consecutive year in 2022, the first time that’s happened since the index’s inception in 1976. As investors look ahead, all eyes are on the Fed’s management of short-term rates amid a tight labor market and persistently high inflation. To provide some context to the current Fed hiking cycle, in Figure 2 we review the pattern of yield movements and fixed income performance over the last seven cycles dating back to 1980.
Over the typical 19-month hiking cycle (cycles have ranged from 12 months to 38 months since 1980), rates initially rise and core fixed income underperforms cash, as happened in 2022 when the Fed began aggressively raising rates. However, before the Fed reaches its peak policy rate (i.e., before it pauses or cuts), intermediate yields begin to fall on average and core fixed income allocations start to meaningfully outperform cash. While cash can mitigate downside risk as markets digest future rate hikes, the time to step out of cash typically comes as the Fed approaches its peak policy rate. As of the date of this publication, we believe the Fed may soon pause its hikes as it evaluates the path of inflation. With yields near decade highs, core fixed income strategies once again may be poised to outperform cash albeit with additional risk.
Bonds have outperformed cash across most environments
Another consideration when evaluating the trade-off between core and cash allocations is a client’s time horizon. Over the minimum horizon of most clients’ long-term investments (three years or more), core bonds have typically outperformed cash. As we show in Figure 3, core bonds have beaten cash 91% of the time over rolling three-year periods since 1978, with an average outperformance of 2.9%. Similarly, strategies in the Morningstar Short-Term Category have also demonstrated outperformance over most periods. Therefore, for most investors with reasonably long investment horizons, elevated cash allocations should be considered a short-term decision given the long-term potential advantages of remaining invested in high quality fixed income.
Advisor positioning in 2022
Against a backdrop of higher yields and higher estimated returns for fixed income but greater near-term Fed uncertainty, let’s look at the average advisor portfolio and highlight key considerations for fixed income investing.
Based on the allocations in Figure 4, we identify three key themes in advisor fixed income portfolios in 2022:
- Relatively large allocations of nearly 20% on average to short-term fixed income
- A balance between core and multi-sector strategies anchoring portfolio allocations
- A tilt toward high yield and bank loans within dedicated credit allocations
However, the category allocations tell only half the story. PIMCO Pro, a digital toolkit to support advisors, provides a deeper understanding of this portfolio’s key fixed income risk factors, including interest rate and credit risk. Figure 5 shows how the allocations above translate to risk characteristics, including relative to U.S. core bond and high yield indices.
Notably, the emphasis on shorter-duration strategies led to a portfolio with nearly half the interest rate risk of the Bloomberg US Aggregate, and a higher level of credit risk exposure but with lower volatility.
While advisors astutely managed interest rate risk in 2022 and took lower overall risk in fixed income, they face new challenges.
The duration question
It’s not just returns that have the potential to improve when yields rise, so too does the risk profile of fixed income. Figure 6 shows that higher starting yields may help cushion the impact of further rate increases. For example, at the recent low of interest rates in July 2020, the Bloomberg US Aggregate had a yield of 1%. This meant that a 100-basis-point (bp) increase in interest rates would lead to a 4.6% decline in the portfolio. However, from today’s higher starting yields, that same shock would result in only a -1.2% annual return. Why? The higher yield offers more income throughout the year to offset the price decline. Furthermore, yields have more room to rally in a risk-off environment, offering better diversification potential.
That last point is important and potentially overlooked in the current environment. For example, if the 10-year yield fell by 100 bps, the return to a core portfolio could potentially outperform cash by almost 5 percentage points. When we apply this same analysis to the average advisor portfolio, we see the additional potential benefits from balanced core and credit allocations – starting yield is higher than the aggregate and cash, while the downside from rising rates is mitigated.
Fixed income investors should also consider the economic outlook. If recent trends continue, we would expect declining inflation and lackluster growth in the wake of an aggressive global rate-hiking cycle, as tightening financial conditions raise recessionary risks (see our recent Cyclical Outlook).
Figure 7 shows that while T-bills have had modestly positive returns in recessions over the last three decades, core bonds saw meaningfully higher returns not only during recessions but during the 12 months preceding those recessions. This result is similar to our analysis of Fed hiking cycles above: Yields tend to fall ahead of economic recessions and ahead of the peak Fed policy rate.
While timing macroeconomic events such as peak policy rates or recessions can be challenging, markets typically begin to correct ahead of these events. In the broader portfolio context, core and other high quality bonds may now offer more attractive downside risk benefits relative to cash in a risk-off environment.
Diversifying your credit allocation
Amid elevated recession risks, questions about how to allocate the credit portion of a fixed income portfolio have increased. On one hand, valuations improved in 2022. On the other, spreads could still widen and defaults rise in a recession or even a further growth slowdown.
An often overlooked consideration is that credit can refer to a number of sectors– such as investment grade corporate credit, high yield corporate credit, securitized credit, municipal credit and emerging markets credit – which can behave quite differently across environments. A diversified credit allocation could help improve risk-adjusted returns, as shown in Figure 8. But as we discussed in "Bonds Are Different,” an active approach in fixed income may be able to provide superior outcomes. The Morningstar Multisector Bond Category had the best risk-adjusted returns of any individual credit sector category, and some funds within that category, have even outperformed the high yield category with lower volatility than investment grade credit strategies. These higher risk-adjusted returns partly reflect the improved risk management benefits of a diversified approach.
In today’s more volatile market, an active and flexible approach to investing in credit markets may be warranted versus more concentrated and risk-seeking strategies.
Looking ahead
With today’s inverted yield curve, many advisors have increased allocations to cash and short-term strategies within their fixed income portfolio. While this was an effective strategy in 2022, it’s important to consider the improved risk and return profile of fixed income strategies given today’s higher yields and the potential for an economic slowdown.
Although most fixed income sectors have trailed cash over the last three years, a core bond allocation as we showed in Figure 3 has outperformed in over 90% of three-year periods over the last 44 years.
PIMCO offers tools to help advisors navigate the investment and behavioral challenges of fixed income investing in the current environment:
- PIMCO Pro’s proprietary analytics allow you to drill into portfolio volatility by risk factor, stress test portfolios, and keep apprised of rapidly moving markets. PIMCO Pro also has tools to assess return potential and evaluate retirement strategies.
- Our solutions team and PIMCO Pro specialists can create customized, deep-dive portfolio reviews that help you understand performance drivers across fixed income, equities and alternatives.
- PIMCO model portfolios are available for direct investment on select investment platforms or to provide guidance on how to address specific investor objectives.
Appendix 3: A Barbell underlying assumptions
Corporate and Municipal Ladder Models are based on a proprietary database of investable securities with a current PIMCO buy rating and excludes securities rated below investment grade and do not represent the portfolio characteristics or performance of an actual account. Security selection criteria for each model portfolio is primarily driven by the specified maturity band (e.g., 1-3 year, 1-5 year, etc.), the average minimum quality allowable for each model (A- for munis, BBB- for corporates) and in the case of munis any indicated state preferences. Security weights are optimized to maximize yield to worst subject to the guidelines just specified and issuer concentration considerations. The information is intended to illustrate what a Corporate and Municipal Ladder portfolio might look like. An actual account’s holdings would vary and would therefore vary from the model. The model portfolio does not represent actual trading and does not reflect the impact that economic and market factors might have on management of the portfolio. No guarantee is being made that the structure or actual account holdings of any portfolio will be the same or that similar returns will be achieved. Model results may vary with each report and over time.
Private Credit: Private Corporate Credit Model. Model risk factor exposures are estimated based on a public equivalent benchmark and alpha estimates derived from historical data on private funds in the Preqin Private Credit Universe. The public market equivalent is duration-hedged high yield. We then add adjustments for illiquidity premia and idiosyncratic risk based on the historical distribution of alpha (relative to the PME benchmark) in the Preqin category. Median and 25th percentile models reflect alpha estimates from the median and 25th percentile of the historical alpha distribution, respectively. Model is provided as a proxy for asset classes where a market index is not available and is not intended or generally made available for investment purposes.
High Yield Muni: The Bloomberg High Yield Municipal Bond Index measures the non-investment grade and non-rated U.S. tax-exempt bond market. It is an unmanaged index made up of dollar-denominated, fixed-rate municipal securities that are rated Ba1/BB+/BB+ or below or non-rated and that meet specified maturity, liquidity, and quality requirements.
IG Muni: Bloomberg Municipal Bond Index consists of a broad selection of investment-grade general obligation and revenue bonds of maturities ranging from one year to 30 years. It is an unmanaged index representative of the tax-exempt bond market. The index is made up of all investment grade municipal bonds issued after 12/31/90 having a remaining maturity of at least one year.
Core Bonds: Bloomberg US Aggregate Index represents securities that are SEC-registered, taxable, and dollar denominated. The index covers the U.S. investment grade fixed rate bond market, with index components for government and corporate securities, mortgage pass-through securities, and asset-backed securities. These major sectors are subdivided into more specific indices that are calculated and reported on a regular basis.
High Yield: Bloomberg U.S. Corporate High-Yield Index covers the USD-denominated, non-investment grade, fixed-rate, taxable corporate bond market. Securities are classified as high-yield if the middle rating of Moody’s, Fitch, and S&P is Ba1/BB+/BB+ or below. The index excludes emerging markets debt.
Featured Participants
Disclosures
Past performance is not a guarantee or a reliable indicator of future results.
All investments contain risk and may lose value. Asset allocation is the process of distributing investments among various classes of investments (e.g., stocks and bonds). It does not guarantee future results, ensure a profit or protect against loss. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, 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. Corporate debt securities are subject to the risk of the issuer’s inability to meet principal and interest payments on the obligation and may also be subject to price volatility due to factors such as interest rate sensitivity, market perception of the creditworthiness of the issuer and general market liquidity. Investing in foreign-denominated and/or -domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. 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. Bank loans are often less liquid than other types of debt instruments and general market and financial conditions may affect the prepayment of bank loans, as such the prepayments cannot be predicted with accuracy. There is no assurance that the liquidation of any collateral from a secured bank loan would satisfy the borrower’s obligation, or that such collateral could be liquidated. Income from municipal bonds is exempt from federal income tax and may be subject to state and local taxes and at times the alternative minimum tax. 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. Diversification does not ensure against loss.
Estimated returns for indices and asset class models are calculated by identifying the risk factors of the index or model, and then multiplying each risk factor by an estimated return. PIMCO uses a proprietary system that automatically identifies the applicable risk factors of the index or model (e.g., duration risk), based on its underlying securities. Each risk factor is then assigned an estimated return – or “risk factor premium” – which is calculated using historical data, valuation metrics and qualitative input provided by PIMCO’s senior investment professionals.
Return assumptions are for illustrative purposes only and are not a prediction or a projection of return. Return assumption is an estimate of what investments may earn on average over the long term. Actual returns may be higher or lower than those shown and may vary substantially over shorter time periods.
Figures are provided for illustrative purposes and are not indicative of the past or future performance of any PIMCO product.
This paper includes hypothetical analysis. HYPOTHETICAL PERFORMANCE RESULTS HAVE MANY INHERENT LIMITATIONS, SOME OF WHICH ARE DESCRIBED BELOW. NO REPRESENTATION IS BEING MADE THAT ANY ACCOUNT WILL OR IS LIKELY TO ACHIEVE PROFITS OR LOSSES SIMILAR TO THOSE SHOWN. IN FACT, THERE ARE FREQUENTLY SHARP DIFFERENCES BETWEEN HYPOTHETICAL PERFORMANCE RESULTS AND THE ACTUAL RESULTS SUBSEQUENTLY ACHIEVED BY ANY PARTICULAR TRADING PROGRAM.
ONE OF THE LIMITATIONS OF HYPOTHETICAL PERFORMANCE RESULTS IS THAT THEY ARE GENERALLY PREPARED WITH THE BENEFIT OF HINDSIGHT. IN ADDITION, HYPOTHETICAL TRADING DOES NOT INVOLVE FINANCIAL RISK, AND NO HYPOTHETICAL TRADING RECORD CAN COMPLETELY ACCOUNT FOR THE IMPACT OF FINANCIAL RISK IN ACTUAL TRADING. FOR EXAMPLE, THE ABILITY TO WITHSTAND LOSSES OR TO ADHERE TO A PARTICULAR TRADING PROGRAM IN SPITE OF TRADING LOSSES ARE MATERIAL POINTS WHICH CAN ALSO ADVERSELY AFFECT ACTUAL TRADING RESULTS. THERE ARE NUMEROUS OTHER FACTORS RELATED TO THE MARKETS IN GENERAL OR TO THE IMPLEMENTATION OF ANY SPECIFIC TRADING PROGRAM WHICH CANNOT BE FULLY ACCOUNTED FOR IN THE PREPARATION OF HYPOTHETICAL PERFORMANCE RESULTS AND ALL OF WHICH CAN ADVERSELY AFFECT ACTUAL TRADING RESULTS.
Stress testing involves asset or portfolio modeling techniques that attempt to simulate possible performance outcomes using historical data and/or hypothetical performance modeling events. These methodologies can include among other things, use of historical data modeling, various factor or market change assumptions, different valuation models and subjective judgments.
PIMCO has historically used factor-based stress analyses that estimate portfolio return sensitivity to various risk factors. Essentially, portfolios are decomposed into different risk factors and shocks are applied to those factors to estimate portfolio responses.
Because of the limitations of these modeling techniques, we make no representation that use of these models will actually reflect future results, or that any investment actually will achieve results similar to those shown. Hypothetical or simulated performance modeling techniques have inherent limitations. These techniques do not predict future actual performance and are limited by assumptions that future market events will behave similarly to historical time periods or theoretical models. Future events very often occur to causal relationships not anticipated by such models, and it should be expected that sharp differences will often occur between the results of these models and actual investment results.
Estimated volatility: We employ a block bootstrap methodology to calculate volatilities. We start by computing historical factor returns that underlie each asset class proxy from January 1997 through the present date. We then draw a set of 12 monthly returns within the dataset to produce an annual return number. This process is repeated 25,000 times to have a return series with 25,000 annualized returns. The standard deviation of these annual returns is used to model the volatility for each factor. We then use the same return series for each factor to compute covariance between factors. Finally, volatility of each asset class proxy is calculated as the sum of variances and covariance of factors that underlie that particular proxy. For each asset class, index, or strategy proxy, we will look at either a point in time estimate or historical average of factor exposures in order to determine the total volatility. Please contact your PIMCO representative for more details on how specific proxy factor exposures are estimated.
Yield to Worst (YTW) is the estimated lowest potential yield that can be received on a bond without the issuer actually defaulting. The YTW is calculated by making worst-case scenario assumptions by calculating the returns that would be received if provisions, including prepayment, call, or sinking fund, are used by the bond's issuer.
The portfolio analysis is based on indices and sample portfolios and no representation is being made that the structure of the average portfolio or any account will remain the same or that similar returns will be achieved. Results shown may not be attained and should not be construed as the only possibilities that exist. Different weightings in the asset allocation illustration will produce different results. Actual results will vary and are subject to change with market conditions. There is no guarantee that results will be achieved. No fees or expenses were included in the estimated results and distribution. The scenarios assume a set of assumptions that may, individually or collectively, not develop over time. The analysis reflected in this information is based upon data at time of analysis.
PIMCO routinely reviews, modifies, and adds risk factors to its proprietary models. Due to the dynamic nature of factors affecting markets, there is no guarantee that simulations will capture all relevant risk factors or that the implementation of any resulting solutions will protect against loss. All investments contain risk and may lose value. Simulated risk analysis contains inherent limitations and is generally prepared with the benefit of hindsight. Realized losses may be larger than predicted by a given model due to additional factors that cannot be accurately forecasted or incorporated into a model based on historical or assumed data.
Statements concerning financial market trends or portfolio strategies are based on current market conditions, which will fluctuate. Different types of investments involve varying degrees of risk. There is no guarantee that these investment strategies will work under all market conditions or are appropriate for all investors and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market. No representation is being made that any account, product, or strategy will or is likely to achieve profits, losses, or results similar to those shown.
Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product.
The PIMCO Models described in this material are available exclusively through investment professionals. PIMCO Models are based on what Pacific Investment Management Company LLC (together with its affiliates, “PIMCO” ) believes to be generally accepted investment theory. PIMCO models are for illustrative purposes only and may not be appropriate for all investors. PIMCO Models are not based on any particularized financial situation, or need, and are not intended to be, and should not be construed as, a forecast, research, investment advice or a recommendation for any specific PIMCO or other strategy, product or service. Individuals should consult with their own financial advisors to determine the most appropriate allocations for their financial situation, including their investment objectives, time frame, risk tolerance, savings and other investments. Volatility is historical and is likely to change over time. PIMCO has not undertaken, and will not undertake, any analysis to determine any specific models’ suitability for specific investors. Strategy availability may be limited to certain investment vehicles; not all investment vehicles may be available to all investors or in all geographical regions. Please contact your PIMCO representative for more information.
It is not possible to invest directly in an unmanaged index or Morningstar category. The categories shown are for illustrative purposes only, and reflects those U.S. funds and share classes with a specific investment approach as categorized by Morningstar. The categories may or may not include PIMCO investment products.
© 2023 Morningstar. All Rights Reserved. The information contained herein: (1) is proprietary to Morningstar and/or its content providers; (2) may not be copied or distributed; and (3) is not warranted to be accurate, complete or timely. Neither Morningstar nor its content providers are responsible for any damages or losses arising from any use of this information. Past performance is no guarantee of future results.
R-Squared is a statistical measure that represents the percentage of a portfolio's movements that can be explained by movements in a benchmark index.
PIMCO does not provide legal or tax advice. Please consult your tax and/or legal counsel for specific tax or legal questions and concerns.
PIMCO as a general matter provides services to qualified institutions, financial intermediaries and institutional investors. Individual investors should contact their own financial professional to determine the most appropriate investment options for their financial situation. This material contains the opinions of the manager and such opinions are subject to change without notice. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. PIMCO is a trademark of Allianz Asset Management of America LLC in the United States and throughout the world. ©2023, PIMCO.
CMR2023-0519-2914688