A back-to-school bond math refresher on timely fixed-income opportunities

Fall is one of the best times of the year: Temperatures ease in the wake of summer’s heat, football season starts, and kids go back to school. With the return to classes approaching, we think it’s a good time to brush up on bond math, given the recent volatility in fixed income and the timely investment opportunities that the tumult has created. Bond investing can be complicated, but investors should be familiar with a few basic mathematic principles. But before we dive into our lesson, let’s review what’s happened so far in 2023 and then explore how bond math may help investors tap into today’s fixed-income return potential.

On the heels of an unusually difficult 2022 for fixed income, bonds have had a bumpy ride so far this year, with year-to-date total returns ranging from a modest +0.31% for the Bloomberg U.S. Aggregate Bond Index (Agg) as of August 15 to a somewhat loftier +1.81% for the Bloomberg U.S. Intermediate Corporate Bond Index.¹ The income that bonds generate for investors through periodic coupon payments has been a big contributor to year-to-date returns, as the Agg yield started the year at 4.68% and was yielding 5.10% as of August 15. Duration—a measure of how much a bond’s price is likely to change given a corresponding change in interest rates—has been a headwind so far, with the 10-year U.S. Treasury bond yield climbing to around 4.21% as of August 15 after starting the year at 3.88%. Credit risk has been rewarded so far this year, with CCC bonds (the lowest rated across the credit quality spectrum) generating a +12.06% return. Overall, high-yield spreads over Treasuries started the year at 4.69% and have since fallen to 3.75%.

The time to repair a roof is when the sun is shining

Riskier parts of the bond market have performed well this year, as U.S. economic data has generally come in better than expected; however, the economy isn’t out of the woods yet. In our view, the full impact of recent interest-rate increases hasn’t yet fully cycled through the U.S. economy, and we could see higher borrowing costs weigh on growth over the next several quarters. U.S. leading economic indicators were recently negative on a year-over-year basis, and indicators of a global economic slowdown have become more apparent, most notably in Europe and China.

However, we’re not in a recession yet, and the attractive bond yields that we’re seeing at a time when the economy isn’t contracting brings to mind a quotation from former U.S. President John F. Kennedy: “The time to repair the roof is when the sun is shining.” Before a potential slowdown unfolds, we would consider moving up in credit quality while valuations reflect better economic growth. As a result, higher-quality bonds represent an opportunity, and bond math can help us better understand the risk/return available today.

Bond math

Bond prices move inversely with yields, so when yields fall, bond prices generally rise, and vice versa. As U.S. Treasury bond prices have fallen over the past year, yields available in the bond market have risen; in fact, the yield of the Agg was recently near the highest in 15 years, dating to the global financial crisis of the 2008/2009 period.¹ In our view, this creates an asymmetric total return profile in which the income component of a bond’s return plus the change in price for bonds is likely to be positive. As a result, in considering a bond’s total return, we believe that the potential gain from price appreciation could exceed that from income generation—a rare occurrence in fixed income.

The yield and duration of the Agg and the 10-year U.S. Treasury yield illustrate the current fixed-income opportunity, which can be demonstrated by doing some math to calculate the potential change in performance over a 12-month time horizon from a bond’s duration across different hypothetical 10-year Treasury yield scenarios combined with the current yield. If the 10-year yield rises to 6.00% over the next 12 months (in our view, this would be the worst-case scenario), the Agg at its August 15 yield should generate a 5.98% loss, based on our forecast; however, if the 10-year yield falls even marginally, an investment in that index should generate positive total returns in the high single digits. We believe that the potential upside would be even greater if the 10-year yield falls back to prepandemic levels of 1.00% to 3.00%, with our forecast indicating potential returns of 20% or more. 

_{Source: FactSet, Inc., as of 8/15/23. This is for illustrative purposes only. This table shows hypothetical performance, assuming there are no spread changes across the U.S. Treasury bond yield curve, holding the yield curve constant. Shading from red to green indicates the degree of negative to positive returns. No forecasts are guaranteed. The Bloomberg U.S. Aggregate Bond Index tracks the performance of U.S. investment-grade bonds in government, asset-backed, and corporate debt markets.  It is not possible to invest directly in an index.}

While bond market volatility has recently been elevated, we continue to go back to the basics and focus on the favorable math in the high-quality bond market. To us, this segment of fixed income continues to present some of the best risk-adjusted total return opportunities across asset classes—and a potentially rewarding lesson for students of the financial markets, with fall just around the corner.

1 FactSet, Inc., as of 8/16/23.