The prior economic analysis suggests that interest rates are at the low end of the “soft landing” range. What do valuations say about the appeal of bonds at this interest rate level? The link between interest rate changes and bond prices is called duration, measuring the sensitivity of a bond’s price to changes in interest rates, with the value representing the percent change in a bond’s price for a 1% change in rates. For example, a bond with a duration of five would lose 5% if interest rates rose 1%.
For valuing bonds, one metric we focus on is the ratio of Duration to Yield, which is in Chart 1. Before the Global Financial Crisis in 2009, this ratio was in a range of 1.0 to 1.4. During the two recent highs for interest rates (October 2023 and April 2024), the yield on the Bloomberg Barclays Aggregate (Agg) exceeded 5%, and the Duration/Yield rate finally returned to that range, reaching 1.4 on 6/30/24. This set up a Q3’24 5% Agg return, as rates declined, boosting prices. With the yield on the Agg back down to 4.2%, the ratio is back up to 1.6. To get back to 1.4 would require a modest rise to 4.8%. With a duration of 6.7, that 0.6% rate rise could cause a 4% price decline, reversing most, but not all, of the Agg’s 5% Q3’24 return that accrued due to falling rates during the period.
Chart 1
This analysis offers insight into other parts of the bond market. Chart 2 shows the same Duration/Yield calculation for the Agg, as well as for the BofA Investment Grade (Igrade) and the BofA High Yield (HiYield) indices. Similar to the Agg, both the Igrade and HiYield ratios reached (unappealing) highs in late 2021 but have since returned to levels comparable to their pre-GFC ratios. Table 1 compares their current ratios to their averages from 2003 to 2007, as a baseline for a “normalized” interest rate environment. The Agg’s significant weighting in government securities keeps its yield lower and duration higher, while escalating credit exposure increases the yield relative to duration for Igrade and HiYield.
Chart 2
Table 1
The better ratios for Igrade and HiYield illustrate why these two segments of the bond market have done well in the “soft landing” market thus far. They have less exposure to interest rate movement, but as long as the economy avoids a recession, they can deliver higher yields.
After falling rates boosted bond prices in Q3’24, some caution is warranted for Fixed Income, as the macro-economic factors suggest an upward bias to rates, and the Duration/Yield benefit suggests valuations are slightly extended. On the plus side, they still offer the benefit of diversification should a recession or other risk cause interest rates to fall further. Should the current soft-landing scenario continue, HiYield and Igrade can benefit as well, as they offer higher yields and lower duration than the Agg. The longer term outlook is reasonable, though Duration’s Boost to Bonds Could be Short Lived.
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