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Economic and political dislocations, recession fears, high inflation and aggressive monetary policy tightening have roiled markets in 2022, producing one of the worst half-year results for global investors since the early 1970s.1 We think the most likely outcome for the rest of the year is that the inflation and recession factors unsettling investors will not recede quickly. Even if the worst of the market setbacks are behind us, volatility and uncertainty will likely linger.
Notably, volatility in the bond market is unusually higher relative to equities (Chart 1). Inflation and fears about the Federal Reserve’s (Fed’s) tightening cycle are partly responsible, but so too is the large price impact associated with rising bond yields from very low starting levels. When traditionally “safe” fixed-income assets are leading the capital markets downward, this leads to questions on how to navigate an environment that has changed markedly from where it was just six months ago.
The answers depend on individual needs, preferences, and tolerances for risk. But in general, the solutions for many will be found in renewed opportunities in income and portfolio rebalancing.
Taking a deeper look at the underlying factors driving asset prices and market volatility, duration is an important concept to consider across asset classes. Duration can be simply defined as the expected holding period of an asset. The longer the duration, the greater the risk (sensitivity to interest-rate changes) and hence, the ex-ante required compensation an investor ought to demand. That’s why, for example, bonds that mature further in the future typically offer higher yields than those with shorter maturities. Moreover, to the extent that payoffs from a long-duration asset arrive much later, as is the case with longer-maturity bonds or growth stocks, their prices will be more sensitive to changes in interest rates and returns over risk-free assets.
While most investors typically associate duration with fixed income, its relationship to stocks is also relevant. For instance, when investors pay high prices for growing companies that are unprofitable today, they are assuming those companies will eventually earn enough to justify higher valuations. In effect, they are partaking in future, not present, profits and dividends.
It follows that the conditions that favor long duration are often the same for growth stocks and bonds, above all the presence of low or falling interest rates. In 2022, interest rates have risen as markets anticipate significant monetary policy tightening to combat high inflation. Unsurprisingly, longer duration bonds and growth stocks have fared poorly.
Against this backdrop of duration underperformance and rising volatility, it is not surprising that growth stocks have also underperformed, particularly relative to value stocks (Chart 2).
The silver lining is that after decades of declining interest rates, higher bond yields are finally beginning to improve income opportunities within fixed-income markets. Prospects for higher income are emerging across different market segments, including corporate bonds, government bonds, and floating rate loans.
As monetary policy is tightening and the risk of recession is rising, income-oriented investors will need to scrutinize credit risk more carefully, which typically increases as corporate financing costs rise and the economy weakens. For example, while the bonds of “defensive” companies (e.g., consumer staples) may offer higher “quality” characteristics, there is an element of interest rate risk due to their longer duration (Chart 3).
Investors may be well-served by a dynamic rebalancing of income and potential capital gains, especially during bouts of heightened volatility and uncertainty. As U.S. Treasury yields have increased across maturities this year, the question arises as to where on the yield curve opportunity and risk are optimized.
In Chart 4, we depict the yield curve (bond yields across different maturities) for U.S. Treasuries at the start of the year and today. The curve has both shifted upwards (meaning all yields have risen) and flattened, resulting in the difference between the three- and 10-year bond yields moving from 0.5% to -0.2%.2
Why would an investor hold a 10-year bond for lesser yield per annum? The answer resides in thinking about the future direction of interest rates and bond yields. If interest rates are near peak levels and may subsequently fall, an investor could get income from 3-year maturities and potential capital gains from 10-year bonds. An optimized allocation between these two could create a risk/reward balance appropriate for an individual investor’s goals. These active choices are becoming more prevalent in the current environment.
Naturally, dynamic rebalancing requires continuous assessment of market prospects, above all for Fed policy, inflation, and growth. To the extent that inflation may soon peak, and growth slows, extending duration makes sense, even more so if coupled with income derived from shorter duration notes and bonds.
That combination may be preferable to taking credit risk, in my view. Using free cash flow as a proxy for bond yields, duration explains the year’s underperformance of last year’s best performers (the FAANGM group of Facebook, Apple, Alphabet, Netflix, Google, and Microsoft) in the S&P 500 Composite Index, which have a duration much higher than the rest of the index, as shown in Chart 5.
What about income derived from equities via dividends? In the United States, the current dividend yield is below both government and corporate bond yields. That is true for the broad market as well as for many securities.
To take one example, the dividend yield on Coca-Cola has remained relatively constant at about 2.8% over the past year.3 On the other hand, weakness in fixed-income markets has pushed up the yield on Coca-Cola’s investment-grade bond maturing in 2032 from about 1.9% at the beginning of the year to over 3.6% by mid-2022.4 Accordingly, conservative investors with an appetite for income might prefer to swap Coca Cola shares for its bonds to enhance their yields in what are likely to otherwise be still volatile market conditions.
Rising interest rates pose risks, as has clearly been on display in 2022. But they also pose opportunity via income and rebalancing. Duration in stocks and bonds will remain under pressure until fundamental and technical factors (i.e., both inflation and Fed risk, as well as risk-parity deleveraging) have run their course.
Dynamic rebalancing can increase returns per unit of risk and deliver better income opportunities for investors. The bottom line is that changing fundamentals warrant revisiting portfolios to ensure that allocations remain consistent with investors’ risk appetites and return expectations.
Stephen Dover, CFA, is Franklin Templeton’s Chief Market Strategist and Head of the Franklin Templeton Investment Institute. Originally published in Stephen Dover’s LinkedIn Newsletter Global Market Perspectives. Follow Stephen Dover on LinkedIn where he posts his thoughts and comments as well as his Global Market Perspectives newsletter.
Notes
1. Source: “Bonds in line for worst year in decades.” Reuters, June 30, 2022.
2. Source: Analysis by Franklin Templeton Institute, Bloomberg.
3. Source: Bloomberg.
4. Source: Analysis by Franklin Templeton Institute, Bloomberg.
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