2023 was quite a year for advisors. I’ve been in discussions with my clients about the massive shift we’ve witnessed — over $1 trillion has poured into money markets, short-term Treasuries, and related funds. Now, balances across short-term cash and equivalents in the U.S. have surpassed an astounding $10 trillion. To put this into perspective, that’s more than the GDP of over 190 countries.
Many of my clients are quick to point out the appeal of these investments. After all, the last time yields were this attractive was over two decades ago, and when you factor in the economic and geopolitical uncertainties, not to mention the unusual bond market volatility, it’s clear why there’s been a rush towards these high-quality, short-duration assets.
In my recent conversations about interest rates, I’ve shared with my clients that, despite growing market calls for a reversal in rates early in 2024, we continue to maintain that short rates will stay elevated into 2024. But that doesn’t mean investors should “Tbill and chill” forever. Looking ahead, we believe it is prudent to start exploring opportunities beyond short-term treasuries, money markets, and cash equivalents. From what we’ve seen, diversifying into other areas of fixed income near or at the end of a Fed tightening cycle has often resulted in better outcomes for investors.
I often explain to my clients that treasury securities, which carry zero credit risk, offer a straightforward investment: the coupon you receive is likely to mirror your annualized total return for the chosen maturity. But when it comes to corporate credit, there’s an added layer of risk and, consequently, a higher yield to compensate for that risk. Bond prices and yields move inversely, and given the sharp rate increases, bond prices have been trading lower. This represents an opportunity for the price component of total return to work in our favor, as bonds are ‘pulled to par’ at maturity.
Bonds Are Well-positioned to Benefit from Higher Yields
Source: Bloomberg. Past performance is no guarantee of future results. Index performance is not illustrative of fund performance. It is not possible to invest directly in an index.
The starting yields in fixed income are currently high, which allows for the absorption of potential interest rate hikes without principal loss. If rates fall, there’s a dual benefit: the pull to par and a positive effect from duration, contributing to total return.
At VanEck, we’re trained to be discerning students of history. History doesn’t always repeat, but when it comes to patterns in the market, it certainly rhymes. Using history as a guide, looking back at the last four hiking cycles, we can see that the average returns across various areas of core fixed income outperformed US Treasury Bills in the 12 and 24 months following the end of a tightening cycle.
Learning from History: Fixed Income Performance Post-Hiking Cycles
Following 12 month returns
Following 24 month returns
Source: Bloomberg. US TBills: ICE BofA US Treasury Bill Index; US IG Corps: Bloomberg US Corporate Index; Muni Bonds: Bloomberg Municipal Index; US HY Corps: ICE BofA High Yield Index; US MBS: Bloomberg Agency Mortgage Backed Securities Index. Past performance is no guarantee of future results. Index performance is not illustrative of fund performance. It is not possible to invest directly in an index.
Spotlight on Quality: BBB and BB Rated Bonds
Looking forward, if we’re to benefit from potential declines in interest rates, it’s important to weigh the risk/reward of extending duration with credit. I’ve been advising my clients that while corporate credit stands fairly strong — with high interest coverage, low leverage ratios, and support from low issuance — after a period of high-interest rates, stress indicators tend to surface. ‘Maturity walls’ pose refinancing risks, and corporate credit can be subject to downgrade risks when economic conditions weaken.
This is why, for 2024, I’m advocating for a focus on higher quality credit. We’ve looked at BBB and BB rated bonds as a ‘sweet spot’ for both relative value and quality. BB rated bonds, in particular, have historically offered the highest Sharpe ratio of all rating categories, benefiting from both discounted bonds moving into high yield and premium bonds returning to investment grade.
For exposure to these market segments, I’ve been discussing options like the VanEck Moody’s Analytics BBB Corporate Bond ETF (MBBB) and the VanEck Fallen Angel High Yield Bond ETF (ANGL). MBBB offers exposure to BBB-rated corporate bonds with attractive valuations and a lower probability of being downgraded to high yield compared to other BBB-rated bonds. ANGL provides access to high yield bonds that were originally issued as investment grade bonds. Fallen angel bonds have historically had higher average credit quality than the broad high yield bond universe.1
For those interested in the municipal bond market, the VanEck Municipal Bond ETF Suite offers a range of choices. The VanEck Intermediate Muni ETF (ITM) is a solid pick for core investment-grade exposure with near benchmark-neutral duration risk. Meanwhile, for those looking to extend duration further in anticipation of long rates coming down, the VanEck Long Muni ETF (MLN) could be a compelling option.
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Originally published 4 January 2024.
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DISCLOSURES
1 Fallen angel bonds represented by ICE US Fallen Angel High Yield 10% Constrained Index and broad high yield represented by ICE BofA US High Yield Index.
ICE BofA US Broad Market Index tracks the performance of US dollar denominated investment grade debt publicly issued and settled in the US domestic market, including US Treasury, quasi-government, corporate, securitized and collateralized securities. ICE BofA US Treasury Bill Index tracks the performance of US Treasury bills. Bloomberg US Corporate Index tracks the investment grade, fixed rate, taxable corporate bond market. Bloomberg Municipal Index tracks the USD-denominated long-term tax-exempt bond market. ICE BofA High Yield Index tracks the performance of below investment grade rated corporate debt publicly issued in the U.S. domestic market. Bloomberg Agency Mortgage Backed Securities Index tracks agency mortgage backed pass-through securities.
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