A compelling entry point

The compelling nature of today’s fixed income entry point is demonstrated in Figure 1, which outlines the potential returns across various fixed income sectors based on current yields and illustrative interest rate movements. This analysis reveals that current starting yields may help anchor return potential for bonds at attractive levels, while also providing a cushion against any further increases in interest rates.

For example, in the multisector bond category below, if 2024 follows a similar path as 2023 and rates end where they start, return expectations are a healthy 6%. If rates rise, they would need to hit nearly 7% (an increase of over 200 basis points (bps)) to turn estimated multisector returns negative.

Categories with more duration, or interest rate sensitivity, such as core bonds and investment grade municipals, may also offer a compelling trade-off. Unlike 2022 when starting yields were much lower, returns today are likely to remain positive even with modest further increases in rates. However, if rates fall even 1 percentage point, returns could climb into double digits.

The one category that shouldn’t benefit from falling rates? Cash investments, as a decline in short rates can quickly translate to a decline in investor returns. That’s not to mention the potential opportunity cost missed by not participating in the drop in interest rates and the likely rally one would experience across most fixed income sectors.

 

Starting conditions matter

Last year was a clear reminder of the pivotal role that high starting yields play in mitigating downside risks and driving positive returns in fixed income. Despite the significant move in rates intra-year with the 10-year yield briefly touching 5% in October, many yields further out on the curve ended the year roughly where they began. In fact, the 10-year yield started and ended the year at exactly the same level of 3.88%.

That round trip in yields allowed bonds to end 2023 on a high note, with returns in the mid to high single digits, as starting yields drove attractive returns. In fact, across most major fixed income sectors, a majority of 2023 returns were driven by yield as opposed to price movements.^Footnote1 The rally in interest rates in November and December simply erased price losses from rising rates earlier in the year.

Additionally, though rates rose through October, most fixed income sectors remained positive or only dipped modestly into negative territory as income from higher yields helped offset price losses. That was not the case in 2022, when much lower starting yields and stronger movements in interest rates and spreads drove most fixed income sectors into negative territory. Importantly, looking forward, starting yields in 2024 are much closer to the high levels of 2023 than the lows of 2022. For example, while the yield on the Bloomberg US Aggregate Bond Index stood at 1.70% to start 2022, those levels were 4.65% and 4.52% to start 2023 and 2024, respectively.

Based on history, bonds may still have considerable upside

History suggests we may still be in the early innings of a bond market rally. As Figure 2 shows, over the last seven Fed rate-hiking cycles since 1978, bond market rallies have tended to last more than a year or two after the final hike.

Additionally, as the Fed begins to ease, front-end yields have tended to fall significantly, which hinders cash returns. Meanwhile, even modest declines in interest rates at longer maturities have tended to lead to notable outperformance for fixed income portfolios due to the price appreciation that falling rates provide.

A review of advisor fixed income positioning in 2023: starting to move cash off the sideline

Over the past two years, many investors boosted cash balances – as evidenced by record levels of assets in money market funds, CDs and bank deposits. But with the Fed likely paused before the expectation of rate cuts later this year, it is a logical time to revisit elevated cash holdings.

Indeed, as yields reached attractive levels, our conversations with advisors in 2023 explored how they could consider increasing allocations to bonds in pursuit of higher returns, while better balancing risks in their fixed income allocations. A review of the allocations of the average advisor portfolio we evaluated in 2023 as shown in Figure 3 highlights a few key themes:

• A balance between core and multisector strategies continued to anchor portfolio allocations.
• Allocations in short-term categories fell by about 5% from 2022 as advisors started to redeploy these assets into longer-maturity fixed income allocations.
• Interest in active fixed income strategies rose given continued market volatility.

Looking ahead

While short rates are higher and cash-equivalent investments may remain attractive in the near term, we believe fixed income looks to be the more compelling long-term investment. Yields across most fixed income sectors are at attractive levels rarely seen in the last twenty years. Additionally, compared with last year, the prospect of falling rates could provide an additional tailwind to bond returns.

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¹ Based on a decomposition of 2023 returns between returns from yields and returns from changes in interest rates or credit spreads for the Bloomberg US Aggregate Index, Bloomberg US Credit Index, Bloomberg MBS Fixed Rate Index, Bloomberg US Corporate High Yield Index, JPM EMBI Global Index, Bloomberg Municipal Bond Index, and Bloomberg High Yield Muni Bond Index.

DISCLOSURES

Past performance is not a guarantee or a reliable indicator of future results.

A word about risk: All investments contain risk and may lose value. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and low interest rate environments increase this risk. Reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. High yield, lower-rated securities involve greater risk than higher-rated securities; portfolios that invest in them may be subject to greater levels of credit and liquidity risk than portfolios that do not. Asset allocation is the process of distributing investments among various classes of investments (e.g., stocks and bonds). It does not guarantee future results, ensure a profit or protect against loss.

Hypothetical illustrations have many inherent limitations, some of which are described below. No representation is being made that any account will or is likely to achieve results similar to those shown. In fact there are frequently sharp differences between hypothetical results and actual results subsequently achieved by any particular trading program.

One of the limitations of hypothetical results is that they are generally prepared with the benefit of hindsight. In additional, hypothetical scenarios do not involve financial risk, and no hypothetical illustration can completely account for the impact of financial risk in actual trading. For example, the ability to withstand losses or to adhere to a particular trading program in spite of trading losses are material points which can also adversely affect actual trading results. There are numerous other factors related to the markets in general or to the implementation if any specific trading program which cannot be fully accounted for in the preparation of a hypothetical illustration and all of which can adversely affect actual results.

Statements concerning financial market trends or portfolio strategies are based on current market conditions, which will fluctuate. Different types of investments involve varying degrees of risk. There is no guarantee that these investment strategies will work under all market conditions or are appropriate for all investors and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market. No representation is being made that any account, product, or strategy will or is likely to achieve profits, losses, or results similar to those shown.

Forecasts, estimates and certain information contained herein are based upon proprietary research and should not be interpreted as investment advice, as an offer or solicitation, nor as the purchase or sale of any financial instrument. Forecasts and estimates have certain inherent limitations, and unlike an actual performance record, do not reflect actual trading, liquidity constraints, fees, and/or other costs. In addition, references to future results should not be construed as an estimate or promise of results that a client portfolio may achieve.

Stress testing involves asset or portfolio modeling techniques that attempt to simulate possible performance outcomes using historical data and/or hypothetical performance modeling events. These methodologies can include among other things, use of historical data modeling, various factor or market change assumptions, different valuation models and subjective judgments. Return assumptions are for illustrative purposes only and are not a prediction or a projection of return. Return assumption is an estimate of what investments may earn on average over the long term. Actual returns may be higher or lower than those shown and may vary substantially over shorter time periods.

Bloomberg U.S. Aggregate Index represents securities that are SEC-registered, taxable, and dollar denominated. The index covers the U.S. investment grade fixed rate bond market, with index components for government and corporate securities, mortgage pass-through securities, and asset-backed securities. These major sectors are subdivided into more specific indices that are calculated and reported on a regular basis. Bloomberg Municipal Bond Index consists of a broad selection of investment-grade general obligation and revenue bonds of maturities ranging from one year to 30 years. It is an unmanaged index representative of the tax-exempt bond market. The index is made up of all investment grade municipal bonds issued after 12/31/90 having a remaining maturity of at least one year. It is not possible to invest directly in an unmanaged index. Bloomberg U.S. Credit Index is an unmanaged index comprised of publicly issued U.S. corporate and specified non-U.S. debentures and secured notes that meet the specified maturity, liquidity, and quality requirements. To qualify, bonds must be SEC-registered. This index was formerly known as the Bloomberg Credit Investment Grade Index. It is not possible to invest directly in an unmanaged index. Bloomberg U.S. MBS Fixed-Rate Index covers the mortgage-backed pass-through securities and hybrid ARM pools of Ginnie Mae (GNMA), Fannie Mae (FNMA), and Freddie Mac (FHLMC). The MBS Index is formed by grouping individual fixed rate MBS pools into generic aggregates. It is not possible to invest directly in an unmanaged index. The Bloomberg US Corporate High Yield Bond Index measures the USD-denominated, high yield, fixed-rate corporate bond market. Securities are classified as high yield if the middle rating of Moody's, Fitch and S&P is Ba1/BB+/BB+ or below. J.P. Morgan Emerging Markets Bond Index (EMBI) Global tracks total returns for United States Dollar denominated debt instruments issued by emerging market sovereign and quasi-sovereign entities: Brady bonds, loans, and Eurobonds. It is not possible to invest directly in an unmanaged index. The Bloomberg High Yield Municipal Bond Index measures the non-investment grade and non-rated U.S. tax-exempt bond market. It is an unmanaged index made up of dollar-denominated, fixed-rate municipal securities that are rated Ba1/BB+/BB+ or below or non-rated and that meet specified maturity, liquidity, and quality requirements. It is not possible to invest directly in an unmanaged index. It is not possible to invest directly in an unmanaged index.

Morningstar Category Index: To create a model for active managers in each Morningstar Category Index PIMCO utilizes a multivariate regression of daily returns on active managers within each Morningstar Category Index versus its category benchmark over the last 10-years ending 30 June 2023 (updated annually) to create a risk model out of key risk factors which are statistically significant. Each risk model is a combination of the benchmark index and the active risk modeled measured described above. Yield for each category is provided by Morningstar as of the month-end stated. For the Multisector Bond and Non-traditional Bond Categories, we use the full category index given the limited passive funds in these categories and lack of appropriate category benchmark. Please contact PIMCO for more details on how each category index model is estimated. For a description of each Morningstar Category please visit: here

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