Investing 101: Fixed Income Basics

Where does yield come from?

Yield is a function of credit risk and tenor:

A bond trades at a given yield because it represents a form of risk (likelihood of payment, currency, market conditions, etc.) and/or tenor (the duration of the debt/bond)

This risk is measured as a spread over treasury yields or the “risk-free rate”.

Source: NAM Consumer Investment Lab

Yield = Risk-Free Rate (Treasuries) + Risk Premium (Spread)

Due to the recent inflationary pressures, the Fed has increased rates to +20-year highs. By increasing rates, the Fed is effectively increasing the yield obtained in the risk-free part of the equation. On the other hand, corporate spreads are trading within historical average as the market doesn’t expect a severe deterioration in credit conditions. The net effect is a substantial increase in yields, while fundamentals remain largely stable. This means that investors who allocate to fixed income are positioning to receive a higher compensation for taking the same level of credit risk. With Treasury yields at the highest levels in over a decade, fixed income yields are offering an attractive entry point.

Rates and Spreads

Over the last 20 years investment grade (IG) yields have averaged 4.4% and traded as low as 1.8% through the mid-2020s. As a result of the recent monetary policy regime, IG yields are now trading at 5.6% as of 22 September 2023, an attractive entry point relative to the historical average.

Source: NAM Consumer Investment Lab. Bloomberg as of 22 September 2023.

Performance Scenarios

Bonds have an inverse relationship to Treasury yields. As yields fall, the price of a bond increases (similarly, bond prices fall as yields increase). The below table illustrates the relationship between rates, spreads, and potential performance. A -120 decrease in yields could result in an approximate +14% gain in IG credit over a 12-month period.

Source: MFS Global Fixed Income: We Have Been Expecting You, Mr. Bond, NAM Consumer Investment Lab.

Historical Performance

Historical performance suggests a strong relationship between starting yields and future returns. In the past, purchasing fixed income with a starting yield close to current levels would result in an average annualized return in the 5-8% range over the next 5 years.

Source: MFS Global Fixed Income: We Have Been Expecting You, Mr. Bond, NAM Consumer Investment Lab.

Risk/Reward Across Different Segments

Source: MFS Global Fixed Income: We Have Been Expecting You, Mr. Bond, NAM Consumer Investment Lab.

Summary

Although current valuations are attractive, it is important to be mindful of the risk/reward dynamics across different fixed income segments; HY spreads tend to widen during economic slowdowns, EM performance is sensitive to FX movements.