We Need to Talk About Yields

Expectations for growth remain disappointing, but fixed-income valuations are improving.

What You Need To Know

It’s clear, in my view, that central banks are willing to sacrifice growth at the altar of quelling inflation; investors are now moving from denial to acceptance of this.
Improvements in valuations are most obvious in fixed-income markets. Investment-grade bonds, for example, are currently yielding as much as 5.6%.
Rising yields means falling prices, but with higher income, a portfolio of bonds can withstand a larger increase in yields before total returns turn negative.

At the beginning of the summer, I asked the question “are we there yet?”, in relation to whether it was time to start thinking about taking on more investment risk. The answer then was no.

At that time, although market valuations had cheapened, we were still concerned that investors were underestimating inflationary risks, being premature in their expectation of a Federal Reserve (Fed) pivot away from interest rate hikes, and had elevated expectations for corporate earnings.

So, what’s changed since then?

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It’s clear, in my view, that central banks are willing to sacrifice growth at the altar of quelling inflation; investors are now moving from denial to acceptance of this. The US 10-year nominal Treasury yield is 4% and the 10-year real yield (that is, adjusted for inflation) is above 1%. Significant rate increases from the major central banks are reflected in prices. So too is a recession, as seen in the inverted yield curve, which is when short-term bond yields are higher than long-term.

As we said last quarter, we are entering the phase of the cycle where investors' expectations for growth are disappointed. This is currently seen in deteriorating corporate-earnings revisions. As liquidity tightens, we have also started to see the first signs of stress; most evidently at the moment in the United Kingdom (UK) government bond market, with potential repercussions for other assets as UK defined-benefit pension plans look to rebuild collateral buffers.

Where Do We Go From Here?

It’s important to remember that this isn’t the first time we've seen bear markets driven by rising interest rates. History doesn't repeat, but it rhymes. The sources of fragility will vary from cycle to cycle, but, as active investors, we have the frameworks to price these challenges and consider relative valuations across asset classes.

The improvement in valuations is most obvious in fixed-income markets. We think it is now time to start talking about yield.

For example, US investment-grade bonds—that is, those deemed by credit agencies to be of the highest quality—have gone from a yield of 2.2% 12 months ago to a yield of 5.6% at the time I write this.

High yield (debt with a credit rating below investment grade) and hard currency (US dollar) emerging-market debt offer yields above 9%.

This shows that we're starting to be rewarded for taking risk in bonds as higher starting yields also act as an income cushion for investors against the impact of further price declines (see FIGURE 1). Rising yields means falling prices, but with higher income a portfolio of bonds can withstand a larger increase in yields before total returns turn negative.

Taking into account the different interest-rate sensitivity (i.e., duration)¹ of bonds, what this means today in the case of US investment-grade bonds is that yields could rise by 0.8% and this would lead to a price fall of 5.6%. However, this would be offset by the 5.6% yield, or income, on offer.

To benefit from yields, you need to be a medium-term investor to withstand any near-term volatility.

What are the caveats? To benefit from yields, you need to be a medium-term investor to withstand any near-term volatility. As we head into recession, credit spreads could widen further.

The credit spread is the difference in yield between bonds of a similar maturity but with different credit quality. As spreads widen, this tends to mean yields rise and prices fall. Even so, we believe it's now possible to construct more positive scenarios for bonds as we head into 2023. We're still cautious on equities as we need corporate earnings expectations to adjust down further.

FIGURE 1

The Yield Cushion: Room to Maneuver Across Various Fixed-Income Categories (%)
Higher income allows for larger yield increases before total returns turn negative

As of 9/30/22. Data based on ICE BAML bond indices other than emerging-market debt (EMD), which are based on JP Morgan. Sources: ICE Data Indices, JP Morgan, Refinitiv, and Schroders.

So, aside from capitulation on the corporate-earnings front, what would be triggers for us to become more bullish? Signs of slowing in either commodity-price inflation or wage growth would be encouraging, as they would allow central banks to back off from raising rates. For now, patience is still a virtue.

For more insights on fixed-income opportunities, talk to your financial professional.

¹ Duration is a measure of the sensitivity of an investment’s price to nominal interest-rate movement.

Important Risks: Investing involves risk, including the possible loss of principal. Fixed-income security risks include credit, liquidity, call, duration, and interest-rate risk. As interest rates rise, bond prices generally fall. • Investments in high-yield (“junk”) bonds involve greater risk of price volatility, illiquidity, and default than higher-rated debt securities. • Foreign investments may be more volatile and less liquid than US investments and are subject to the risk of currency fluctuations and adverse political, economic, and regulatory developments. These risks may be greater, and include additional risks, for investments in emerging markets. • Obligations of US Government agencies are supported by varying degrees of credit but are generally not backed by the full faith and credit of the US Government.

The views expressed herein are those of Schroders Investment Management (Schroders), are for informational purposes only, and are subject to change based on prevailing market, economic, and other conditions. The views expressed may not reflect the opinions of Hartford Funds or any other sub-adviser to our funds. The opinions stated in this document include some forecasted views. Schroders believes that they are basing their expectations and beliefs on reasonable assumptions within the bounds of what they currently know. The views and information discussed should not be construed as research, a recommendation, or investment advice, nor should they be considered an offer or solicitation to buy or sell any security. This information is current at the time of writing and may not be reproduced or distributed in whole or in part, for any purpose, without the express written consent of Schroders or Hartford Funds.

WP712 2561501

Insight from our sub-adviser Schroders Investment Management

Johanna Kyrklund

Group CIO and Co-Head of Investment