The Big Mac on Fixed Income Valuation EJINSIGHT


Entry points are not just for tactical investors. It is generally assumed that only tactical investors pay close attention to market entry levels. But we would say that in fixed income investments, entry points strongly influence longer-term expected returns, because starting yields and future returns are generally linked in most fixed income asset classes. It depends on how the total returns of fixed income securities are generated, with income generally being their largest and most stable component over time.

Current yields may be attractive by historical standards. Fixed income yields are trading near their highest levels in a decade, with all major subgroups above the 90th percentile (Table 1). This was the result of the recent rate correction combined with a significant widening of spreads. The rise in yields since the start of the year has been significant in the fixed income universe, where yields in the high yield space have increased by more than 400 basis points, sovereign debt yields emerging-markets yields increased by around 350 basis points and investment-grade yields increased by around 235 to 245 basis points, depending on the region (Figure 2).

Historically, starting yields have tended to influence future yields. Historical data suggests a relationship between entry returns and later returns. In US investment grade corporate credit, for example, the current yield is 4.69%. During historical periods where the initial return was between 4.5% and 4.8%, subsequent 5-year returns ranged between 0.3% and 6.5%, with a median return of 4.6%. When analyzing historical market conditions, we found that the lower returns could be explained by a sharp upward correction in US rates that took place over the next few years, which was notably the This was the case in 2003 and 2017. Significant US rate hikes are now unlikely, in our view, especially with the risk of recession becoming more of a concern for investors.

Global aggregate returns could potentially be attractive from a valuation perspective. Similarly, there appears to be a relationship between starting returns and future returns for the Global Aggregate Index. With returns today at 2.9%, we analyzed historical periods where the starting return ranged between 2.8% and 3.1% and found that subsequent 5-year returns ranged between 2, 9% and 4.9%, with a median of 4.5%.

Emerging market sovereign debt yields could represent attractive entry levels for strategic investors. Running the same type of analysis for emerging market sovereign debt, where yields are currently 8.8%, we found that in historical periods where the starting yield was between 8.5% and 9, 0%, subsequent 5-year returns ranged between 3.4% and 10.8%. , with a median return of 7.2%.

A significant valuation cushion has been rebuilt following the correction in global fixed income yields. This is best illustrated by looking at total return equilibrium returns, which show how much returns would have to rise before a year of coupon income is offset and the resulting total return is zero. The higher the equilibrium return, the lower the probability of realizing a zero total return and the better an investor’s cushion against rising rates. Break-even returns have nearly doubled across most asset classes since the start of the year. This valuation cushion is particularly important for US high yield and European high yield, which would need to experience a yield increase of more than 200 basis points from current levels to produce zero returns over the next year.

Stress test of the strategic power of fixed income investments. Another way to illustrate the potentially attractive valuation of long-term fixed income securities is to stress test the impact of a one-time 50 basis point increase in US Treasury rates on a credit portfolio. IG US Corporate Index, using the Bloomberg US Aggregate Corporate Index. The results of our stress testing process show that after an initial loss due to the initial rate shock, the simulated returns would recover over time and eventually reach an annualized simulated return of 4.5% after ten years, as higher reinvestment rates compensate for the initial loss over time. This suggests that the simulated 10-year annualized returns will be broadly consistent with the starting yield, further confirming the hypothesis that the starting yield may be an important determinant of long-term returns and highlights the role of income in as the long-term driver of fixed income securities. total returns.

We believe the fixed income valuation backdrop may be attractive, particularly for investors with a longer time horizon. Over the past decade, low yields in fixed income securities have put off investors, and some have reduced their allocations to the asset class as they seek higher yielding (and potentially riskier) assets. Given its lackluster performance in recent quarters, it’s no surprise that fixed income securities have fallen out of favor. However, the recent rise in yields and spreads has significantly changed the momentum and led to a substantial improvement in the valuation backdrop. We therefore encourage strategic investors to review their bond allocations.

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Source: Bloomberg, MFS


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