Fixed Income

The Fixed Income (bonds) asset class is made up of many different entities who issue bonds such as Federal governments, local governments (cities, counties, states), and corporations. Bonds can also be issued to help finance consumer debt such as credit card loans, mortgages, student loans and auto loans. Fixed income securities typically make fixed interest payments at pre-set dates and return the principal to investors when the bond reaches maturity. As a result, investors know exactly when and how much cash they will receive from their investments, unlike with equities.

The terminology for bonds is different than for equities, so let’s discuss a few key concepts for bonds. The yield on a bond represents the expected annual return assuming the bond is held until maturity and all payments are received by the investor and reinvested at the same rate.

For example, the 10-Year U.S. Treasury had a nominal yield of 0.68% as of 7/1/20. This means that an investor in that bond should expect to earn 0.68% per year for the life of that bond. Bonds that are issued by entities other than the Federal government, should offer higher yields than U.S. Treasuries to reflect their higher level of risk. For example, a 10-Year corporate bond may yield 1.68%, which would be the annual expected return on that bond over 10 years. In this example, the corporate bond’s yield is 1% higher than the 10-Year Treasury (1.68%-0.68%), which is the spread of that bond over the treasury bond. Spreads are used in the bond market to compare how much extra return you would receive relative to a Treasury bond and are a key driver of investment decisions.

Historical Returns

Historically, returns for fixed income have been lower than for equities due to bonds having much lower risk. Despite having lower returns than equities, returns for bonds have been positive over time.

So, what determines the yield for government and corporate bonds over time? One of the key drivers of returns for government bonds is the current level of inflation as well as inflation expectations. As discussed in the Equities primer, inflation is currently at low levels and the bond market expects inflation to stay low as shown by looking at TIPS breakeven spreads. U.S. government bonds also enjoy safe-haven status, and are viewed as a hedge against recessions by both domestic and international investors. 

Additionally, the Fed’s largescale asset purchases following the Financial Crisis are estimated to have reduced the 10-year Treasury yield by 0.4-0.8%. The other key driver of U.S. government bond yields is the maturity of the bond. Bonds with a longer maturity have more risk of default and so investors should be rewarded with a higher yield. 5-Year Treasuries currently have a yield of 0.29% compared to 0.65% for 10-year Treasuries and 1.43% for 30-Year Treasuries.

Non-government bonds such as corporate bonds, offer greater returns than government bonds reflecting their higher level of risk. For example, corporate bonds typically have yields ranging from 1% to 3% higher than government bonds, reflecting the fact that corporations are riskier borrowers than the federal government. For Investment Grade corporate issuers, average spread for their bonds over Treasuries is typically between 1.0-1.2%, reflecting credit risk (the risk of downgrade/default), as well as the fact that Investment Grade corporate bonds are much less liquid that Treasuries. Given that spread, you would expect Investment Grade Corporate bonds to generate returns that are 1-1.2% higher than for treasuries.

However, the actual realized excess returns for Investment Grade Corporate Bonds has been in the 0.3-0.4% range, due to 0.3-0.4% from Index Investors being forced to sell corporate bond when they are downgraded to Speculative Grade, 0.2-0.4% from losses from Investment Grade corporate issuers defaulting on their debt, and up to 0.2% of losses from spreads widening, Currently the spread on Investment Grade Corporate bonds is around 1.5% but was as high as 4% in Mid-March of 2020 due to concerns over the financial impact of COVID-19 on corporate issuers.

Investment Grade corporate issuers rarely default with the 10-year cumulative default rate at only 1.9% from 1981-2019. For Speculative Grade corporate bonds, spreads can be 3-10% higher than Treasuries to reflect the much higher risk of these companies defaulting, and not making their scheduled interest and principal payments. The 10-year cumulative default rate for Speculative Grade corporate bonds is 20.2% from 1981-2019, so clearly there is a much higher default risk for Speculative Grade corporate bonds compared to Investment Grade corporate bonds.

Credit Rating Agency Ratings Scale

rating scale

 

Projected returns

Going forward I expect returns to be weak across a variety of fixed income asset classes. The below chart shows the yield and average maturity for a range of fixed income securities and benchmarks. The yield on a fixed income security or index represents roughly what the return will be over the life of that security or index. Unfortunately, nominal yields are in the 1-2% range for most of these sectors, while real yields are negative across most of these sectors. This implies an expected nominal return of 1-2%, and an expected real return of -1-0%. This is due to a variety of reasons discussed above such as weak inflation expectations, large scale fixed income purchases from the Federal Reserve as a result of the Financial Crisis, and strong demand from international investors due to the even weaker yields abroad. As a result, fixed income as an asset class is mostly unattractive for individual investors unless you expect the U.S. to experience massive deflation.

 fixed income benchmarks

  • Treasuries/Agencies. These are bonds issued by the U.S. Treasury as well as government agencies backed by the U.S. government. These securities offer lower yields than other fixed income asset classes given the strength of the U.S. government and the perceived ability for the U.S. to pay back its debt at maturity. However, given where yields on Treasuries currently are, there is not much upside from here. For example, if you bought a 10-Year US Treasury today your expected nominal annual return over the next 10 years is 0.65% and your expected real annual return is -1.35%. If the yield on the 10-YR Treasury goes to 0% the price of the bond would increase by 6%. In my mind that is the maximum upside for the bond. However, if the yield on the 10-YR go up to 2%, where it’s yield was to start the year, the price of the bond would decline by roughly 12%. Clearly there is much more downside risk buying Treasuries unless you expect significant deflation.

 

  • Municipals. Bonds issued by local municipalities including states, cities, as well as hospitals, airports, and public infrastructure such as municipal electric utilities. Most municipal bonds have strong credit quality as these entities typically can raise taxes and have other mechanisms to secure inexpensive financing. However, the quality of municipal bonds does vary substantially from AAA rated states and cities, to private universities in default as well as debt issued by Puerto Rico. Municipal bonds offer attractive tax benefits and are generally invested in by investors in higher tax brackets. Specifically, you don’t have to pay Federal income tax on the interest income, and you can avoid state and local taxes if you buy municipal bonds issued by your home state. These attractive tax benefits exist to help municipal borrowers fund projects at a lower cost of capital. At times yields on muni bonds are lower than treasuries due to the tax advantages but currently nominal yields on 10-Year AAA rated Municipal bonds are at 0.90%, 141% of 10-year Treasuries and 5-year AAA rated Municipal bonds have a nominal yield of 0.41%, 137% of 5-year Treasuries. Munis are viewed as cheap when their ratio is above 100% of Treasuries and expensive when under 100% relative to Treasuries.

 

  • Corporates. Bonds issued by corporations and which are generally unsecured from the strongest borrowers but can be secured debt from weaker borrowers. Here again the quality of the companies issuing bonds varies dramatically from strong investment grade such as Microsoft, Apple, Berkshire Hathaway to Speculative Grade companies that are in default or near default. As of 6/29/20 the Investment Grade Corporate Bond Index had a nominal yield of 2.2%, and an average maturity of roughly 12 years. The High Yield Corporate Bond Index has a nominal yield of 6.9% with an average maturity of roughly 6 years. Given the yields in Investment Grade and High Yield, I believe High Yield corporate bonds are currently more attractive. Specifically, BB rated corporate bonds, which are the strongest companies within the Speculative Grade universe have a nominal yield of 5.11%, which represents a spread of 4.7%. Normally yields would be higher for corporate bonds during a large recession, but the Federal Reserve has been buying individual investment grade and high yield bonds as well as ETF’s of corporate bonds as part of its monetary stimulus driven by COVID-19. The Federal Reserve has stepped in to provide liquidity, but ultimately yields are much lower than they would be based on the economic fundamentals.

 

  • Securitized. This is a broad category that includes bonds backed by residential mortgages, commercial mortgages, credit cards, auto loans, misc. The overall securitized index has a nominal yield of 1.4% and an average maturity of 3.9 years as of 6/29/20. The Securitized universe is extremely broad with nominal yields ranging from 1% for many categories of Asset Backed securities (ABS) to 1-2% for many Mortgage Backed Securities (MBS), to 2-3% for Commercial Mortgage Backed Securities (CMBS), for high quality bonds across these asset classes. These nominal yields represent expected returns across these assets.

1 https://www.spglobal.com/ratings/en/research/articles/200429-default-transition-and-recovery-2019-annual-global-corporate-default-and-rating-transition-study-11444862


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