Why Accept More Risk for Comparable Yield?

Bond Concepts by Madison Investments

With interest rates across the yield curve luring investors back to fixed income, we think it prudent for advisors and investors to consider the risk and return tradeoff in their fixed income allocation and ensure they are being adequately paid for risks, particularly duration (interest rate risk). It is easy to revert to the same tendencies that caused challenges for many investors in 2022 and assume that strategies with longer durations will deliver greater yield and total return potential than intermediate-term strategies. However, when you examine current valuations and historical performance patterns, the data tells a different story.

Yield per Unit of Duration Favors Intermediate Bonds

Yield per unit of duration is one metric that can help investors compare and value bonds with different maturities. Think of it as return potential per unit of interest rate risk. Currently, the Bloomberg Aggregate Bond Index, which contains bonds with maturities ranging from 1 to 30 years, yields 5.05% with a duration of 6.1. Its yield per unit of duration sits near its historical average of 0.8. The Bloomberg Intermediate Government/Credit Bond Index, comprised of bonds maturing in 1 to 10 years, currently yields 4.86% with a duration of 3.7. Its yield per unit of duration is significantly above its historical average of 0.9. This prompts a fundamental question: why accept more risk for seemingly comparable yields?

Interest Rate Outlook and the Myth of Parallel Shifts

Investors should also consider the monetary policy environment and the potential for cuts to the Fed Funds rate. During periods of easing monetary policy, conventional wisdom would suggest that long-term (10-year and longer) bonds with greater sensitivity 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 maturities in the intermediate range have historically performed in line with or better than bonds with longer durations during easing.

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

In our analysis, we charted the returns of the aggregate and intermediate bond indices beginning two months before the first Fed Funds rate cut and ending two months after the final cut. 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

Understanding the Federal Reserve's influence is crucial in navigating fixed income markets. The historical playbook, especially during the mid-to-late 90s, suggests that the Fed might keep rates higher for longer, and when cuts do occur, they might be modest. Investors must not solely rely on rate-cut expectations but also consider the nuanced responses of different bond maturities.

Even if the Fed aggressively cuts interest rates next year, as many in the market predict, the impact on all yields might not mirror the magnitude of the cuts. By reevaluating fixed income allocations, with a focus on yield per unit of duration and a keen awareness of the Fed's impact across the entire curve, investors can better position portfolios for resilience and sustainable returns.