Historically, intermediate core plus bond funds have significantly outperformed money market and ultra short bond funds in the 12 months following a Federal Reserve hiking cycle, as longer duration bond investors have benefited from higher yields and more attractive relative value. While investors have added $614.1 billion to money market funds so far in 2023, there may be a better investment opportunity with longer duration assets should the Federal Reserve decide to take a pause in the current rate hiking cycle.
Performance shows the average for Morningstar categories referenced (Money Market Funds, Ultra Short Bond Funds, and Intermediate Core Plus Bond Funds).
Historically, when a Federal Reserve rate-hiking cycle has ended, longer-duration spread sectors have materially outperformed more traditional fixed-income and shorter-duration spread sectors in the following 12 months.
Corporate debt had strong returns during the previous Federal Reserve rate-hike cycle ending in 2018, continued to have strong returns through the pause, and outperformed other asset classes through the full cycle.
Yields across corporate credit are currently far higher than at the end of 2021. In this environment, the additional credit risk may be worth the additional yield for investors.
The Federal Reserve has predicted it will raise interest rates two more times in 2023. But current market expectations are for a rate pause for the rest of the year. Here's what happened the last time the Fed paused rates.
Consumer spending has been slightly up year-over-year (as of July 22, 2023), according to Bank of America credit-card spending data. While spending was significantly down in categories such as online electronics, furniture and gas, consumers have been paying more on dining and entertainment.
In July, the S&P 500 Equal Weight Index and the Russell 2000 Value Index outperformed the S&P 500. But for this year so far, the tech-heavy Russell 1000 has led the way—up 33%.
Historically, when investment-grade corporate bonds, high-yield bonds and bank loans have reached the same price and yield levels as today's, they've generated a 12-month return well above each asset class’s 20-year annualized return (7.20% for high-yield bonds; 4.65% for investment-grade corporate bonds; and 4.65% for bank loans).
Historically, if investors wanted higher levels of yield, they would have to take on higher levels of volatility. But over the past three years, bank loans have had lower levels of volatility than most investment-grade areas of the fixed-income market with higher levels of yield. Bank loans currently offer investors more than two times the yield of the Bloomberg US Aggregate Bond Index, while having delivered 32% less volatility over the past three years.
Small-cap stocks take on more risk than their large cap counterparts, but for patient long-term investors, that risk may be compensated with outsized returns. Historically, small-cap stocks have averaged a 10.5% return, outperforming their large-cap counterparts by 2.5% on an average annualized basis. This has been mainly driven by their higher growth rates, domestic focus, and smaller size and scale, making them more innovative and nimble, as well as their economically sensitive nature.
Small-cap historical returns show that below-average return periods have been followed by those with above-average returns. Specifically, in periods where the Russell 2000 Index 5 year trailing return has been below the historical average of 10.5%, the forward 5 year return is higher 100% of the time and averages 14.9%.
Not only is timing the markets an impossible feat but could be costly from a returns perspective. As the chart below depicts, once the Russell 2000 troughs, the forward 1 year return is 63.8% but missing just the first five trading days of the recovery decreases your return by 12%, and missing the first month cuts the return in half.
Over the past 12 months, longer-duration asset classes have seen $99.4 billion in net inflows vs. $22.8 billion in outflows from shorter-duration categories.1 To date, this move to duration—sparked largely by the potential ending of rate hikes by the Fed—has seen bank-loan funds outperform long government bond, intermediate core bond and intermediate government bond funds in the second half of 2022, all of 2022 and 2023 year-to-date.
With yields across corporate credit currently far higher than at the end of 2021, investors may now assess whether additional credit risk has been worth the extra pickup in yield.
In 2022, investors had few places to hide amid one of the worst market years on record. But one fixed-income asset class performed far better than others: Bank loans.
Some investors have started to add duration to their fixed-income investments, expecting a Federal Reserve pause in interest-rate hikes. But given the current curve inversion across various areas of fixed income, investors have been giving up yield for the sake of adding duration. With the Fed still reiterating a data-dependent approach, investors may be caught off guard if the Fed continues to raise rates without a pause.
In 2022, investors had few places to hide amid one of the worst market years on record. But one fixed-income asset class performed far better than others: Bank loans.
Fixed-income investors in intermediate core bond funds gave back 105% and 71% of their 5-year and 10-year return, respectively, in 2022. Investors who added exposure to short-term bond funds fared better; the average short-term bond fund finished 2022 with a return of -5.22% vs. -13.32% for the average intermediate core bond fund. This was the greatest margin of outperformance for short-term bond funds over intermediate core bond funds since the inception of the Morningstar Short Term Bond Category.
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