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Throw Caution to the Wind? Not So Fast

Key Points
  • The Federal Reserve suggested it may pause its interest rate hikes and markets rallied—but we’re still cautious.

  • Fed patience should keep bond yields steady while avoiding an inverted yield curve.

  • Credit risk is still a concern.

We ended 2018 with a cautious outlook. Our concerns centered on the effect of the Federal Reserve’s policy tightening on the economy and the market’s appetite for risk, at a time when valuations for bonds were high. We suggested a cautious approach to riskier areas of the fixed income markets and moving up in credit quality, a strategy that worked well late last year as low-credit-quality bonds declined sharply in the fourth quarter on concerns about slowing economic growth and trade disputes.

However, markets have rebounded in early 2019 in response to indications from the Federal Reserve that the central bank would “pause” its interest rate hikes. The shift in tone by the Fed helped spur a steep rally in the riskier areas of the market, including high-yield bonds and bank loans, relative to Treasury bond prices. We expect the revival in risk appetite will continue for a while, but we’re not ready to throw all caution to the wind. We still see plenty of reasons for investors to remain cautious in 2019.

Fed patience should keep yields steady

Despite the shift in the Fed’s tone, our outlook for intermediate- to longer-term rates hasn’t changed. We continue to believe that the peak in 10-year Treasury bond yields for this cycle was passed last fall at 3.25%, and that yields are likely to trade in a range of about 2.5% to 3% in the first half of this year. Because longer-term yields are driven more by prospects for economic growth and inflation than by Fed policy, current 10-year yields near 2.8% appear to be reasonably valued. Inflation expectations have been edging lower over the past few months as last year’s fiscal stimulus wears off and trade conflicts weigh on global growth. Based on a measure of inflation expectations that the Fed monitors—the five-year, five-year forward rate—the market is expecting inflation to remain near 2%, about 80 basis points lower than 10-year Treasury yields. The difference between current yields and expected inflation is near the high end of the five-year average. It would likely take a surprising burst of strong growth or inflation to send yields significantly higher.

The market expects average inflation of 1.9% in January 2024, while the current 10-year Treasury yield is 2.8%

Based on the five-year, five-year forward inflation expectation rate, the market expects average inflation of 1.9% in January 2024, while the current 10-year Treasury yield is 2.8%.

 

Notes: A measure of the average expected inflation over the five-year period that begins five years from the date data are reported. The rates are comprised of generic United States breakeven forward rates: nominal forward 5 years minus U.S. inflation-linked bonds forward 5 years.

Source: Bloomberg 5-Year 5-Year Forward Inflation Expectation Rate (USGG5Y5Y Index) and 10-year Treasury yields (USGG10Y INDEX). Daily data as of 1/17/2019.

Moreover, 10-year Treasury yields also appear in line with market expectations for Fed policy. Historically, 10-year Treasury yields and the federal funds rate have converged at cyclical peaks. Current 10-year yields are already at levels consistent with one to two more rate hikes by the Fed, while market expectations for further rate hikes have fallen to near zero.

A yield curve inversion appears less likely

A more patient approach to rate hikes by the Fed will likely help avoid an inversion of the yield curve in the first half of 2019. The spread between 3-month Treasury bill yields and 10-year Treasury bond yields has narrowed significantly over the past few years as the Fed has moved short-term interest rates higher. So far, the narrowing is consistent with the normal pattern during cycles of monetary policy tightening. However, there were concerns that if the Fed proceeded to hike rates as rapidly as last year, it could cause short-term rates to move higher than long-term rates. Slowing down or halting rate hikes should ease those concerns.

The gap between 3-month and 10-year Treasury yields has narrowed during the past few years

The gap between 3-month Treasury yields and 10-year Treasury yields was 335 basis points in on June 30, 2009, but had narrowed to 64 basis points by November 30, 2018.

 

Source: Market Matrix US Sell 3 Month & Buy 10 Year Bond Yield Spread (USYC3M10 Index). Daily data as of 1/18/2019.

Note: This spread is a calculated Bloomberg yield spread that replicates selling the current three-month U.S. Treasury Note and buying the current 10-year U.S. Treasury Note, then factoring the differences by 100.  A basis point is one one-hundredth of one percent, or 0.01%  (100 basis points is equivalent to 1%).

Also, an easier stance by the Fed sends the signal that it is not trying to curb growth or inflation, which should keep longer-term bond yields from falling significantly. In the past, the yield curve has flattened when the Fed was hiking rates, but inversions have been infrequent—and usually associated with a surprising slowdown in economic growth and/or very aggressive tightening by the Fed due to high inflation. Investors worry about yield curve inversions because they result in tight credit conditions and have preceded recessions in the past. By holding off on more rate hikes, the yield curve should stay positively sloped, although still quite flat. Given the shape of the yield curve and our outlook for 10-year Treasury yields to remain in a range, we suggest investors consider adding some duration to portfolios. We suggest aiming for an average duration in the five- to seven-year area.  However, as five-year yields are relatively low compared to other maturities, investors could consider a “barbell” approach, splitting the allocation between short-term maturities of one to two years and longer-term maturities of seven to 10 years.

The Treasury yield curve is still positively sloped  

As of January 23, 2019, the Treasury yield curve was still sloping upward, with one-year Treasury yields at 2.58%, five-year yields at 2.57%, 10-year yields at 2.74% and 30-year yields at 3.06% as of January 23, 2019.

Source: Bloomberg.  Data as of 1/23/2019.

Credit risk is still a concern

Our concerns about the riskier segments of the bond market have not abated, despite the rebound in corporate bond and bank loan prices since the Fed’s recent shift to a more lenient policy stance. Easier financial conditions are helpful for companies looking to borrow money, but the fundamental problems of too much debt on corporate balance sheets, a slowing economy and deteriorating lending standards are still intact. Yet valuations aren’t providing a lot of extra yield to compensate for the elevated risks. Credit spreads—the yield difference between corporate bonds and Treasuries of similar maturity—have increased from the lowest levels of 2018, but are only near the longer-term average.

Investment-grade credit spreads are increasing with rising risks

The average option-adjusted spread for the Bloomberg Barclays U.S. Corporate High-Yield Index widened to 5.26% as of 12/31/2018, up from 3.16% on 9/28/2018. OAS then narrowed to 4.33% as of 1/22/2019. The longer-term average since January 2010 is 4.92%.

Note: Option-adjusted spreads (OAS) are quoted as a fixed spread, or differential, over U.S. Treasury issues. OAS is a method used in calculating the relative value of a fixed income security containing an embedded option, such as a borrower's option to prepay a loan. An excess return is calculated for each security in the index as the difference between the security’s total return and the total return on Treasuries in the corresponding duration cell. These excess returns are aggregated to the index level.

Source: Bloomberg. Bloomberg Barclays U.S. Corporate Bond Index, Average OAS. Monthly data as of 1/19/2019.

High-yield bond spreads are near the long-term average

The average option-adjusted spread for the Bloomberg Barclays U.S. Corporate Bond Index widened to 1.53% as of 12/31/2018, up from 1.06% on 9/28/2018. OAS then narrowed to 1.37% as of 1/22/2019. The longer-term average since January 2010 is 1.43%.

Note: Option-adjusted spreads (OAS) are quoted as a fixed spread, or differential, over U.S. Treasury issues. OAS is a method used in calculating the relative value of a fixed income security containing an embedded option, such as a borrower's option to prepay a loan. An excess return is calculated for each security in the index as the difference between the security’s total return and the total return on Treasuries in the corresponding duration cell. These excess returns are aggregated to the index level.

Source: Bloomberg. Bloomberg Barclays U.S. Corporate High-Yield Bond Index, Average OAS using monthly data as of 1/19/2019.

For investors who have significant exposure to credit risk, we would suggest using the rally in these markets as an opportunity to reassess how much exposure is appropriate. We would make sure you’re not overly exposed to the higher-risk asset classes, such as high-yield bonds and bank loans, because they tend to be sensitive to changes in the economic outlook. Our general guidance is to stay in the higher-credit-quality tiers of the corporate bond market.

Creating a portfolio for cautious times

Finding the right mix of bonds for a portfolio depends on several factors—your goals, your investing time frame and how much tolerance you have for market volatility. Most investors will want to hold some low-risk fixed income for capital preservation. If you have a shorter time horizon and/or your goal is primarily capital preservation, then you should aim for short-term, relatively low-risk investments such as Treasuries, certificates of deposit (CDs) and short-term bond funds for the majority of your portfolio.

If you have an intermediate (four to 10 years) investment horizon, then you may be willing to take a bit more risk to get more income. Investment-grade corporate, municipal and international bonds might be appropriate to add to core Treasury holdings.

For a more aggressive investor who has a long investing time horizon and a higher tolerance for risk, emerging-market, high-yield bonds, and bank loans usually offer higher yields for the added risk of downgrades or defaults, while interest rate risk can make long-term Treasuries volatile. Meanwhile, preferred securities have elevated credit risk and interest rate risk.

Objectives

Capital Preservation

Balanced Income

Aggressive Income

Time frame

Short-term (ex. 0-4 Years)

Intermediate Term (ex. 4-10 Years)

Long-term (ex. 10+ Years)

 

Treasuries

Investment Grade Corporate Bonds

Emerging Market Bonds

 

CDs

Investment Grade Municipal Bonds

Preferred Securities

 

Short-term bond funds

U.S. Agency Bonds

High-Yield

   

Securitized Bonds

Long-term Treasuries

   

International Developed Market Bonds

Bank Loans

Source: Schwab Center for Financial Research, as of 1/23/2019.

Diversification is also a factor to take into consideration. While most bonds offer some diversification from stocks, some do not. Historically, long-term Treasuries have provided the most diversification, as their prices will tend to move in the opposite direction of stocks, especially when the stock market falls. However, high-yield bonds and other aggressive income investments provide little benefit because their prices tend to move in the same direction as stocks most of the time, an effect known as “positive correlation.”

During the 5 years ended March 2018, the Bloomberg Barclays U.S. Treasury Long Bond Index had a negative 0.22 correlation with the S&P 500 index, while the U.S. Corporate Bond Index correlation was 0.18 and the High-Yield Bond Index correlation was 0.65.

Note: Correlation is a statistical measure of how two investments have historically moved in relation to each other, and ranges from -1 to +1. A correlation of 1 indicates a perfect positive correlation, while a correlation of -1 indicates a perfect negative correlation. A correlation of zero means the assets are not correlated. Correlations shown represent an equal-weighted average of the correlations of each asset class with the S&P 500 during the 5-year period between April 2013 and March 2018. Indexes representing the investment types are: Bloomberg Barclays U.S. Aggregate Bond Index (U.S. Agg), Bloomberg Barclays U.S. Treasury Inflation-Protected Securities Index (TIPS), Bloomberg Barclays Municipal Bond Index (Municipals), Bloomberg Barclays U.S. Corporate Bond Index (IG Corporates), Bloomberg Barclays Emerging Market USD Index (USD EM), ICE BofA Merrill Lynch Fixed Rate Preferred Stock Index (Preferreds), Bloomberg Barclays U.S. Corporate High-Yield Bond Index (High-Yield), and the Bloomberg Barclays U.S. Treasury Long Bond Index (Long Treasuries). Diversification strategies do not ensure a profit and do not protect against losses in declining markets. Source: Bloomberg.

It has been a good start to the year for fixed income investors, but the concerns that drove us to a cautious stance last year remain. We expect slowing economic growth due to the lagged effect of Fed tightening, the waning influence of tax cuts, a slowing global economy and trade conflicts. Slower growth can lead to a decline in credit quality, which could trigger ratings downgrades or defaults. The Fed’s apparent shift toward pausing interest rate hikes is positive, but doesn’t offset these concerns, in our view. We continue to suggest a cautious stance in the fixed income markets.

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Important Disclosures:

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market or economic conditions. Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.

Past performance is no guarantee of future results and the opinions presented cannot be viewed as an indicator of future performance.

Indexes are unmanaged, do not incur management fees, costs and expenses, and cannot be invested in directly.

Diversification strategies do not ensure a profit and do not protect against losses in declining markets.

Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed-income investments are subject to various other risks including changes in credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications and other factors. Lower-rated securities are subject to greater credit risk, default risk, and liquidity risk.

International investments involve additional risks, which include differences in financial accounting standards, currency fluctuations, geopolitical risk, foreign taxes and regulations, and the potential for illiquid markets. Investing in emerging markets may accentuate these risks.

Tax-exempt bonds are not necessarily suitable for all investors. Information related to a security's tax-exempt status (federal and in-state) is obtained from third parties, and Schwab does not guarantee its accuracy. Tax-exempt income may be subject to the alternative minimum tax. Capital appreciation from bond funds and discounted bonds may be subject to state or local taxes. Capital gains are not exempt from federal income tax.

Treasury Inflation Protected Securities (TIPS) are inflation-linked securities issued by the U.S. government whose principal value is adjusted periodically in accordance with the rise and fall in the inflation rate. Thus, the dividend amount payable is also impacted by variations in the inflation rate, as it is based upon the principal value of the bond. It may fluctuate up or down. Repayment at maturity is guaranteed by the U.S. government and may be adjusted for inflation to become the greater of the original face amount at issuance or that face amount plus an adjustment for inflation.

Preferred securities are often callable, meaning the issuing company may redeem the security at a certain price after a certain date. Such call features may affect yield. Preferred securities generally have lower credit ratings and a lower claim to assets than the issuer's individual bonds. Like bonds, prices of preferred securities tend to move inversely with interest rates, so they are subject to increased loss of principal during periods of rising interest rates. Investment value will fluctuate, and preferred securities, when sold before maturity, may be worth more or less than original cost. Preferred securities are subject to various other risks including changes in interest rates and credit quality, default risks, market valuations, liquidity, prepayments, early redemption, deferral risk, corporate events, tax ramifications, and other factors.

The Bloomberg Barclays U.S. Aggregate Bond Index is an index that 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.

The Bloomberg Barclays U.S. Corporate Bond Index is an index that covers the U.S. dollar-denominated investment-grade, fixed-rate, taxable corporate bond market. Securities are included if rated investment-grade or higher using the middle rating of Moody’s, S&P, and Fitch credit rating services.

The Bloomberg Barclays U.S. Treasury Inflation Protected Securities (TIPS) Index is an index that tracks inflation-protected securities issued by the U.S. Treasury that have at least one year remaining to maturity and are rated investment grade.

The Bloomberg Barclays U.S. Municipal Bond Index is a broad-based benchmark that measures the investment grade, U.S. dollar-denominated, fixed tax exempt bond market. The index includes state and local general obligation, revenue, insured and pre-refunded bonds.

The Bloomberg Barclays Emerging Markets USD Aggregate Bond Index  includes USD-denominated debt from emerging markets in the following regions: Americas, Europe, Middle East, Africa, and Asia.

The ICE BofA Merrill Lynch Fixed Rate Preferred Securities Index tracks the performance of fixed-rate USD-denominated preferred securities issued in the U.S. domestic market.

The Bloomberg Barclays U.S. Corporate High-Yield Bond Index covers the USD-denominated, non-investment-grade, fixed-rate, taxable 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.

The Bloomberg Barclays U.S. Long Treasury Bond Index includes all public obligations of the U.S. Treasury, excluding foreign-targeted issues with maturities of 10 years or longer.

The S&P 500 Index is an index that is designed to measure the performance of 500 leading publicly traded companies from a broad range of industries.

Source: Bloomberg Index Services Limited. BLOOMBERG® is a trademark and service mark of Bloomberg Finance L.P. and its affiliates (collectively “Bloomberg”). BARCLAYS® is a trademark and service mark of Barclays Bank Plc (collectively with its affiliates, “Barclays”), used under license. Bloomberg or Bloomberg’s licensors, including Barclays, own all proprietary rights in the Bloomberg Barclays Indices. Neither Bloomberg nor Barclays approves or endorses this material, or guarantees the accuracy or completeness of any information herein, or makes any warranty, express or implied, as to the results to be obtained therefrom and, to the maximum extent allowed by law, neither shall have any liability or responsibility for injury or damages arising in connection therewith.

The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.

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