Rising rates have severely impacted the performance of most traditional fixed-income strategies. But this isn’t the first time the Agg has experienced steep declines to start a year, and this isn’t the first time it’s been driven by higher rates and soaring inflation.

You’ve undoubtedly been inundated with stories bringing us back to the late 1970s and early 1980. CPI prints year-over-year were 13.3% and 12.5% for 1979 and 1980, respectively. By comparison, the highest print we’ve seen year-to-date was 8.6% in May 2022 vs. 8.5% for the previous month. Remember that in 1980, the Fed was aggressively hiking the federal-funds rate, which reached a record high of 20%. 

Weak Start, Strong Finish

By the end of February 1980, the Agg hit a low of -8.78%. Remarkably, however, the Agg finished the year in the positive, climbing back to 2.71% by December 1980. This type of bounce-back hasn’t been entirely unusual either, especially for strategies that invest in higher-quality fixed-income. Historically, large drawdowns in the Agg were subsequently followed by periods of positive returns. In fact, bonds averaged a return of 7.72% one year after posting poor quarterly returns (FIGURE 1). With that in mind, this may be an opportune time for financial professionals to consider adding high-quality discounted bonds (which may now be better positioned against a recession), while also seeking to take advantage of any tax-loss harvesting opportunities that may exist. 

One reason why bonds have historically rebounded after poor starts to a year is because conditions changed to a more favorable environment (i.e., lower rates or tighter spreads). Another is related to the self-healing nature of bonds: Higher rates and wider spreads can drive prices lower for a time, but as long as a bond doesn’t default, its face value eventually recovers back to par.

Higher rates and wider spreads can drive bond prices lower for a time. But as long as a bond doesn't default, its face value eventually recovers back to par.

Investment Grade: It's Required

To qualify as investment grade, the components of the Agg, as well as most traditional core and core-plus bond strategies, are required to be rated investment grade (IG) by at least two of three major rating agencies. However, almost 70% of the bonds in the Agg are a combination of US government debt (42.1%) and US mortgage-backed securities (MBS) that are supported by government-sponsored entities (GSEs) (27.8%). From a purely credit perspective, the US has never defaulted on its debt. For a fee, GSEs guarantee MBS investors that timely repayments of principal and interest will occur even if the borrowers default. The GSEs have an additional layer of support, whether explicit (Ginnie Mae) or implicit (Fannie Mae and Freddie Mac) whereby they are backed by the full faith and credit of the US government.

The next-largest component of the Agg is IG bonds (24.5%). The issuers are corporations that could default because they don't have the benefit of a governmental backstop—but they've also historically met their obligations time and time again. Over a 50-year period, IG corporate bonds have defaulted less than 1% of the time (FIGURE 2).

Discount Opportunities

With default risk fairly low and with current prices at a relative discount, the components that make up the Agg and most traditional core and core-plus bond funds actually look quite attractive to us at the moment. Coming into 2022, despite the rate backup during the course of 2021, most bonds in the Agg were still priced at a decent premium. However, a lot has changed with the markets since then. High-quality bonds once priced at a premium are now being priced at a significant discount for the first time in many years (FIGURE 3).

At the time of this writing, holding the US Treasury parts of the Agg to maturity could result in a return greater than 9% from capital appreciation alone. The average coupon on the Treasury components is still historically low. But unless you’re expecting the US to default, the additional pickup from capital appreciation should look very attractive to investors—especially those on the conservative end of the spectrum. 

There have been six calendar years in which the Fed hiked consistently throughout the year. In none of those years were rate hikes mirrored by changes in the 10-year rate.

What About Fed Hikes?

The pushback on this argument is that higher rates are coming, and the discounts will only be pushed deeper. Shouldn’t investors wait for the inevitable higher rates? It’s an entirely valid consideration. After all, as of this writing, the market is anticipating six or seven additional rate hikes, and the Fed seems fully committed to fighting inflation. But the common misconception is that by raising its target rate, the Fed automatically pushes Treasury rates higher. That doesn’t have to be the case.

The Fed has no control on the longer end of the yield curve. Dating back to the start of the 2000s, there have been six calendar years in which the Fed hiked consistently throughout the whole year. In none of those years were changes in the federal-funds rate mirrored by changes in the 10-year rate. In half of those instances, 10-year rates actually declined while the Fed was hiking short-term rates (FIGURE 4).

Using history as a guide, the possibility of meaningfully higher Treasury rates may have diminished at this point.

Potential Recession Strategy

Finally, there’s the ever-present question of whether we’re headed into a recession. Some economists are convinced there’s no way to avoid one, while others believe the economy is resilient enough to handle a possible slowdown without slipping into a full-blown recession. Nonetheless, even the staunchest optimists have been hedging their predictions by ascribing some level of probability to a possible recession. Historically and intuitively, recessionary periods lead to lower rates as a result of the market’s flight-to-quality (FIGURE 5). 

That said, the challenging start for fixed income in 2022 may have provided the unexpected benefit of putting bonds in a better position to help provide diversification relative to equities. The significant backup in rates across the yield curve has created more of a buffer between today’s levels and the historically low level of US rates seen in 2020 and 2021. After the Fed raised its target rate by 75 basis points (bps) on June 15, 2022, the US 10-Year Treasury closed the day at 3.29%—a full 175 bps above where it stood in January 2020, just before we entered the global pandemic. Present-day levels could make for a far better entry point if the US slips into a recession. 

Now may be the ideal time to book a sizable tax loss and rotate into a self-healing strategy priced at a discount.

Don't Forget Tax-Loss Harvesting

The final benefit that shouldn’t be overlooked is an investor’s ability to potentially use tax-loss harvesting of meaningful losses to help offset potential capital gains. While it’s also currently a down year in equity markets, fixed-income capital losses that exceed capital gains in a year may be used to offset ordinary taxable income up to $3,000 in any future tax year, indefinitely, until exhausted. Now may be an appropriate time to book a sizable loss in one strategy, whether fixed income or equity, and rotate into a self-healing strategy priced at a discount that could potentially help reduce drawdowns if the economy were to stumble into recession. 

Bottom Line

Potential opportunities for fixed-income investors may now exist on a number of fronts. High-quality bonds are now priced at a discount, potentially providing upside for the first time in years. Fixed-income markets—in particular, high-quality issues with relatively low default risk—have bounced back from challenging periods in the past, a process aided by the self-healing nature of bonds themselves. The recent rate back-up may also provide investors with opportunities for diversification relative to equities and a potential downside hedge in the event of a recession. Finally, tax-loss harvesting opportunities may now exist to help offset capital gains. Given the multiple potential benefits, it’s clear that bonds may offer potential value on multiple fronts not seen in quite some time.