Recent bond market volatility has been painful for fixed-income investors seeking stability within their portfolios. The silver lining? This backdrop sets the stage for active management to add value.
Bond market volatility has been on the rise over the last several years, with yields climbing on the back of the U.S. Federal Reserve’s (Fed’s) unprecedented and ambitious tightening cycle. These efforts have been successful, bringing inflation down from 9.1% in June 2022 to 3.4% at the end of 2023. However, moderating inflation that remains above the Fed’s target has led to an uncertain path forward as the central bank waits to see whether further action might be warranted.
For now, the Fed has decided to keep rates steady since the July 2023 meeting. Even so, fixed-income markets continue to see volatility, with the 10-year U.S. Treasury yield rising and falling sharply as investors try to ascertain what might lie ahead.
Bond yields were volatile in 2023
10-year U.S. Treasury yield (%)
Source: U.S. Department of the Treasury, as of December 31, 2023.
Though the closely watched measure started and ended the year at nearly the same level, the 10-year U.S. Treasury yield passed through a wide range in the time between, leading to substantial volatility for bond markets. Looking ahead, we believe that yields could experience continued chop until there is greater clarity around the economic growth outlook and interest-rate policy. Against this backdrop, active management stands positioned to find opportunities within fixed income.
We continue to favor quality
The economy has proven to be more resilient than we would have expected, but we still believe that now is the time to favor quality within fixed-income portfolios. Economic data is mixed, but some measures suggest that a recession could be ahead. Even still, high-yield spreads have been steadily narrowing and are now trading well inside their historical average.
High-yield spreads have been narrowing over the last several years
Spread (bps)
Source: Bloomberg, ICE Data Indices, as of December 31, 2023. Bps refers to basis points.
A deteriorating macroeconomic environment would likely cause high-yield spreads to widen, weighing on returns. An economic slowdown would also have the potential to increase the default rate, particularly for high-yield issuers, which would further drag down performance.
Balancing quality and yield
In our view, allocating toward an area of the market such as agency mortgage-backed securities (MBS) can provide investors with the ability to move up in quality and add liquidity without sacrificing yield.
Over the last year, agency MBS spreads have experienced a pronounced widening relative to other spread sectors, presenting a relative value opportunity. While spreads have tightened recently as interest rates have rallied, current levels remain well outside of their long-term averages, suggesting that this part of the market remains attractive on a relative value basis.
Agency MBS spreads remain above their long-term average
Agency MBS spread relative to 5- and 10-year U.S. Treasuries (bps)
Source: Bloomberg, Manulife Investment Management, as of December 31, 2023. Bps refers to basis points. Past performance does not guarantee future results.
In our view, the flexibility of an actively managed strategy can be imperative to navigate the MBS market, which faces several unique challenges. With the Fed’s ownership of MBS concentrated in lower-coupon securities and higher mortgage rates providing little incentive for borrowers to refinance or prepay their mortgages, we believe that tilting toward high-coupon pools may allow for investors to benefit from higher relative yields while still being insulated from supply or prepayment risks.
Though the market has proven to be resilient so far and lower-quality securities have been rewarded, this could change quickly once the market breaks. Tilting a portfolio toward high-quality and highly liquid areas of the market such as agency MBS or U.S. Treasuries can provide dry powder, allowing active managers to be nimble, taking advantage of any opportunities in investment-grade corporate bonds if and when spreads widen.
Going beyond duration
Broadly speaking, having a lower duration than the benchmark can be beneficial in rising-rate environments while the inverse is true when rates are falling. However, active management can take this one step further by going beyond duration, positioning the portfolio to benefit from anticipated changes in the shape of the yield curve. This means that even if the duration of the portfolio is in line with that of the benchmark, tilting toward certain maturities has the potential to add value. We can see the benefit of yield curve positioning strategies by looking at the historical performance of intermediate-term bonds in the period following the Fed’s last rate hike in prior cycles.
Intermediate bonds typically outperform after the Fed's final rate hike
Source: Bloomberg, as of December 31, 2023. Returns greater than one year are annualized. Yield curve belly performance is represented by the Bloomberg U.S. 5–7 Year Treasury Bond Index. Yield curve wing performance weighs the blended Bloomberg U.S. 1–3 Year Treasury Bond Index and Bloomberg U.S. 25+ Year Treasury Bond Index to match the duration of the Bloomberg U.S. 5–7 Year Treasury Bond Index.
As the Fed nears the end of this tightening cycle, we believe there is benefit to shifting exposure toward the middle, or the belly, of the yield curve. History tells us that the 10-year U.S. Treasury yield tends to fall in advance of a pivot in Fed policy, a phenomenon that leads to intermediate bonds typically outperforming a duration-matched portfolio of short and longer maturity bonds.
Getting defensive
Active managers can also take advantage of their flexibility by tilting portfolios toward specific areas of the market. Certain sectors or industries might have a more favorable or gloomy outlook due to factors, including our position in the market cycle, impact from government regulations, or current valuations, among others.
Though the industry has come under investor scrutiny since last spring, we’re currently finding opportunity within banking and financial services. These companies are highly regulated, making them more defensive in nature and also trading at compelling valuations. This area of the market could also benefit if the yield curve steepens, allowing them to lend out funds at higher interest rates than they pay to borrow from depositors.
We also have a favorable view on utilities, another defensive sector. The Inflation Reduction Act, passed in the summer of 2022, provided significant funding and incentives for utility providers to update their infrastructure, which should provide support for these issues. These bonds also look attractive from a relative value perspective.
Along with favoring more defensive areas of the market, we believe it prudent to reduce exposure to more cyclical areas of the market which could come under pressure as we continue through this late-cycle environment.
Many levers to pull
As evidenced by the last several years, fixed-income markets are dynamic and can shift rapidly. The bond market is also quite broad, with different areas of the market each navigating their own set of risks and challenges. With many different levers to pull, active managers have the flexibility and resources to uncover pockets of opportunity, creating the potential for outperformance even as market uncertainty lingers.
Important Disclosures
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