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Fixed income: traversing a steeper slope

ANDREW WHYTE, CFA JIM JACKSON, CFA 30-Apr-2021

climbing

The past year was marked by plenty of excitement—the type that most fixed income investors could do without. A global pandemic, a significant, if brief, recession, abnormal capital markets behavior, and extraordinary monetary easing and expansionary fiscal policies. The combination whip¬sawed fixed income markets over the course of 2020, even as bond investors benefitted from solid returns across all sectors for the full year.


The first quarter of 2021 has been a little more sedate but still quite challenging. Rising rates on U.S. Treasuries and a steepening yield curve caused returns to go negative across investment-grade sectors during the first three months of the year. The rising expectations for inflation, coupled with a commitment to keep the near-term federal funds rate close to zero, have conspired to push longer Treasury rates higher and thus have steepened the yield curve.

So how can investors prepare for the steeper terrain ahead in this difficult environment? There are various actions investors can take to shape their fixed income portfolios, but those investors concerned about the rising rate environment—and who isn’t— might want to consider increasing credit exposure.


Consider the negative correlation we have seen between Treasury rates and credits spreads—which are defined as the additional compensation investors require to hold securities that aren’t as safe and liquid as those issued by the U.S. Treasury. Our analysis shows that credit spreads are persistently negatively correlated with Treasury rates, so that when Treasury rates rise, credit spreads have historically not followed (see accompanying graph). We note that an increase in rates this year was met with a tightening of investment-grade credit spreads by five basis points (bps) and a tightening of below-investment-grade credit spreads of 50 bps.  


What’s the key takeaway for bond investors? We believe that the current rising rate and steeper yield curve environment—a challenge that some bond investors dread—actually provides intriguing opportunities for fixed income investors who are willing to increase their credit exposure. Therefore, we remain steadfast in our philosophy that income drives returns over time, and that careful and diligent credit selection is the path to enhance portfolio income. 


If investors expect rates to continue climbing, they should consider how credit spreads can act as a buffer to this rate increase. This conclusion is based on our research, which has shown that credit spreads are historically negatively correlated with Treasury rates. Additionally, we believe that credit spreads offer attractive, incremental income over Treasury securities, further insulating the negative impact of rising rates. So while others worry about the rising rates and the steep slope, we see this environment as ideal for active managers who favor corporate credit and can selectively invest across credit quality buckets, sectors, and asset classes. This, in our view, seems like a better way forward compared to a passive approach or a strategy that simply shadows the Bloomberg Barclays U.S. Aggregate Bond Index.