As interest rates have returned to levels higher than much of the past decade, investors and advisors are taking a fresh look at fixed income. As they do, it is important to weigh risk versus return.

A few basics help frame the discussion. Bond prices and yields move in opposite directions, and some bonds react more sharply to interest-rate changes than others. That sensitivity is called duration. Investors also earn spread, or yield above Treasuries, for taking on credit risk from borrowers other than the U.S. government.

It is easy to assume that longer-term bonds always offer higher yields and better return potential, but that mindset hurt many investors in 2022 when rates rose quickly. Looking at today’s valuations and historical patterns, the data suggests a more balanced approach, especially regarding how much interest-rate and credit risk you take on.

More interest rate risk generally means more spread risk

If an investor expects interest rates to fall, the instinct may be to take on more interest rate risk by allocating to a broad Aggregate or Core Bond strategy. However, the total risk of a portfolio is a function not only of interest rate risk, often measured by duration, but also of what is called spread risk, which is made up of credit, structure, and liquidity risk.

While the Aggregate Bond Index has 61% more duration (interest rate) risk than the Intermediate Index (5.93 vs 3.69), the additional exposure to spread risk is equally dramatic (49.83% vs. 29.09%). In bonds, spread risk is not simply a function of how much of something you own but also the average maturity or duration of that exposure. The longer the maturity and duration, the more you are exposed to changes in spreads.

Why does this matter? Generally, interest rate and spread risk are relatively uncorrelated. If the economy is doing well, spread risk is rewarded as spreads on risk assets shrink, but rates tend to increase. Conversely, when the economy is doing poorly, spreads widen, but rates fall. This helps explain why an intermediate portfolio, with much lower exposure to both interest rate and spread risk, can be a good, less volatile alternative to a longer-maturity structure, especially when the additional yield available on risk assets is near historically tight levels. Today, that trade-off is especially stark: the spread between the Intermediate Govt/Credit Index and the Aggregate Bond Index sits in the 95th percentile of the last 25 years — very little compensation for the added risk relative to history.

Interest Rate Outlook and the Myth of Parallel Shifts

Investors should also consider the monetary policy environment and the potential path for the Fed Funds rate. During periods of easing monetary policy, conventional wisdom would suggest that long-term (10-year and longer) bonds, which are more sensitive to interest rate movements, would benefit the most from falling yields. However, duration does not contribute to performance in these periods as some may expect, as bonds with intermediate maturities have historically performed in line with, or better than, those with longer durations during easing.

The main reason for this is that interest rates across the curve do not move in parallel. Yields in the 1-5 year range tend to be more impacted by the Fed, while the long end of the curve may not move down as much as investors might assume.

In our analysis, we charted the returns of the aggregate and intermediate bond indices from two months before the first Fed Funds rate cut to two months after the final cut, or until the present in the case of the current cycle. Take out the unprecedented circumstances of COVID, and intermediate bonds performed in line with or better than aggregate bonds in each of the previous cycles.

Yield Curve Shifts

Conclusion

The return of yield has presented investors with one of the better opportunities of the past 20 years to invest in fixed income. Given the risk dynamics in the bond market and historical yield curve trends, we argue that the intermediate maturity segment offers a superior risk/reward profile compared with longer maturity alternatives.

This is not to say that longer, aggregate-like portfolios are an inappropriate investment for everyone. Many investors want or need that longer duration exposure—think of life insurance companies, pension plans, or investors with very long investment horizons. Some retail investors may see a higher yield on a longer-maturity bond than on an intermediate bond and decide to buy and hold to lock in that rate for an extended period.

However, for many investors seeking traditional exposure to domestic bond markets, we believe now is a good time to invest, and intermediate-maturity bonds offer the greatest risk-adjusted total return potential.