A Strategic Approach to Fixed Income Today

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The Opportunity Set Has Evolved

For anyone in the investment business for less than 20 years, it’s possible to incorrectly assume that the institutional model of allocating capital to risk assets to achieve return objectives and meet financial obligations has always been consistent. In fact, it was much simpler just 30 years ago; asset allocators simply needed to by bonds to achieve their return and risk objectives. Figure 1 from Callan shows this starting point in the 1990s and the evolution over the decades to more forms of risk capital—a development driven primarily by the fall in bond yields, but also in the case of pensions, the temptation to underfund liabilities.

Source: Callan Capital Market Assumptions (CMA). Annual data as of December 31, 2023. CMAs are developed by consultants and represent long-term, return expectations across asset classes. A complete, long-term CMA may also include expected volatility, or standard deviation of returns, as well as the expected return correlation and other projections. Treasuries are risk-free debt securities issued by the U.S. government and secured by its full faith and credit. Income from Treasury securities are exempt from state and local taxes. Past performance is not a reliable indicator or guarantee of future results. The historical data shown in the chart above are for illustrative purposes only and do not represent any specific portfolio managed by Lord Abbett.

With the need for excess returns and commensurate risk came another need: to balance the risk with an allocation to risk-reducing assets. The most common implementation became an allocation to U.S. Treasuries and investment-grade bonds. These risk-reducing allocations are often referred to as the “fixed-income anchor” because they diversify risk-asset volatility, preserve capital, and provide liquidity, especially during a risk-off environment.

Now, however, as income has returned to fixed income, investors have an opportunity to reevaluate the paradigm of risk capital and fixed-income anchors. As Callan notes in the 2024 portion of Figure 1, it is possible to reduce portfolio volatility by adding assets to the fixed-income anchor. It also may be possible to reduce illiquidity, complexity, and fees. Therefore, we think it’s the perfect time to revisit the implementation question: how should a strategic allocation to fixed income be constructed today?

Cross-Asset Correlations Have Changed

There is a pressing reason for reevaluation of fixed income beyond the increased yield available: rate-based implementations are losing effectiveness as an all-weather diversifier (the anchor). Figure 2 details two-year rolling correlations between equities and Treasuries and shows a recent reversal of the negative correlation that gave Treasury bonds their diversification properties. Scanning the long-run history of this correlation, it’s clear that positive correlation between equities and Treasuries is common, especially in periods marked by elevated inflation.

Figure 2.

Rolling two-year stock and bond correlation, January 1, 1930-April 30, 2024

Source: Ibbotson, Bloomberg, and Lord Abbett. Data as of April 30, 2024. Stock-bond correlation represented by Ibbotson Associates SBBI Long-Term Government Bond Index and S&P 500® Index. Past performance is not a reliable indicator or guarantee of future results. The historical data shown in the chart above are for illustrative purposes only and do not represent any specific portfolio managed by Lord Abbett.

The reason for that dynamism in correlation is relatively clear as well. Keynesian monetary policy responds to a slowing of economic growth, which is generally accompanied by equity declines, by lowering interest rates, benefiting bonds. But when rising inflation is driving equity declines, the same countercyclical policy of lowering rates would compound the problem. Without that lever, stocks and bonds suffer and benefit together in inflationary environments.

We believe the current inflationary environment behind positive stock/bond correlation may well be a secular theme. The drivers are many:

A reconfiguring of supply chains around the world in response to weaknesses uncovered during COVID-19 and geopolitical risks.
A single-family housing shortage in developed economies around the world.
Continued spending on energy transition initiatives, as well as related limiting of current energy and commodity supplies.
Demographic shifts to older populations, limiting labor supply in services-based economies.
Persistent deficit spending by developed economies around the world.

Implications for the Fixed-Income Anchor

The elevated inflation we expect is likely to result in continued recoupling of stocks and bonds—a challenging situation for asset allocators relying on rate-oriented bonds as a key diversifier of risk assets. Rate volatility, which has been higher than equity volatility at times during the last several years, is also likely to remain elevated as the market expectations shift to this higher-for-longer environment.

As Treasuries price in higher inflation and, at the same time, lose their effectiveness as diversifiers, the market may demand more compensation for the risk of holding long-term bonds. Figure 3 shows that this “term premium” has been near zero or negative since the advent of quantitative easing. An increase to 1%–3% levels seen during and after other inflationary periods would be a difficult transition period for long Treasury Bond investors.

Figure 3.

Term premium and U.S. Consumer Price Index (CPI), January 1, 1961–April 30, 2024

Source: Bloomberg and the Federal Reserve Bank of New York, as represented by ACMTP10. Data as of April 30, 2024. Term premium is defined as the compensation that investors require for bearing the risk that interest rates may change over the life of a bond. For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

The backdrop of curve steepening would be likely if the U.S. Federal Reserve (Fed) were to remain dovish despite persistent inflation. If the Fed were to turn more hawkish and keep rates elevated to bring inflation down more quickly and decisively, the outcome may be a persistently flat yield curve. There is precedence for this, as shown in Figure 4, during the 1994–2000 period, which was the last soft landing achieved by the Fed. Note that the two- to 10-year spread remained positive but under the historical average during nearly this entire period.

Figure 4.

10-year Treasury constant maturity yield minus 2-year Treasury constant maturity yield, February 1, 1977–April 30, 2024

Source: Bloomberg and the Federal Reserve Bank of St. Louis (FRED). Data as April 30, 2024. Series is calculated as the spread between 10-Year Treasury Constant Maturity and 2-Year Treasury Constant Maturity. Steep, flat, and inverted yield curve periods determined by a 2-year and 10-year U.S. Treasury yield spread of 91 basis points (bps) or higher, 0-90 bps, and under 0 bps, respectively. For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment. Past performance is not a reliable indicator or guarantee of future results.

How should allocators think about this new environment characterized by persistently flat or possibly steepening curves and increased rate volatility?

We have two long-term recommendations:

Limiting the rate exposure, which may compound equity movements, rather than diversifying those moves, as it did consistently in the 30 years prior.
Adding credit to fixed-income allocations to diversify rate risk.

Limiting Rate Exposure

Most aggregate-based fixed-income strategies are nearly entirely rate risk. With over 70% in Treasuries and agency mortgage-backed securities (MBS) and over six years of interest-rate duration, the modest credit risk from the investment-grade corporates in the Bloomberg Aggregate Bond Index is overwhelmed by the rate risk. To this point, Figure 5 shows the tracking error expected from the Bloomberg U.S. Aggregate Bond Index by driver of the volatility.

Figure 5.

Contributing factors (in percent) to expected tracking error volatility for the Bloomberg U.S. Aggregate Bond Index, as of March 31, 2024

Source: Bloomberg. Data as of March 31, 2024. Tracking error is the standard deviation of returns relative to a portfolio or benchmark. The chart shows the degree to which each listed factor contributes to overall volatility displayed by the Bloomberg U.S. Aggregate Bond Index (“Agg”), based on an ex-ante (derived from estimates) risk model from Bloomberg. For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment. Past performance is not a reliable indicator or guarantee of future results.

This rate risk presents a challenge in an environment of curve steepening or in a flatter-for-longer environment that may accompany a soft landing. Figure 6 shows the returns of short-duration indexes relative to full-duration indexes in inverted, flat, and steep yield curve environments. Note that short duration outperforms long duration in every environment, except a steep one, and does so with a fraction of the volatility.

Figure 6.

Historical index returns during flat, steep, and inverted yield curves

Source: Bloomberg, ICE Data Indices LLC, and Lord Abbett. Data as of March 31, 2024. Steep, flat, and inverted yield curve periods determined by a 2-year and 10-year U.S. Treasury yield spread of 91 basis points (bps) or higher, 0-90 bps, and under 0 bps, respectively, between 06/30/1976 and 12/31/2023. Returns shown for each index are annualized. Returns shown for All Periods are an average of the annualized returns across all three yield curve environments. Indexes: Bloomberg U.S. Corporate Bond Index, ICE BofA U.S. Corporate 1-3 Year Index, Bloomberg U.S. Aggregate Bond Index, and Bloomberg 1-3 Year U.S. Government/Credit Index. For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment. Past performance is not a reliable indicator or guarantee of future results.

Adding Credit to Diversify the Fixed-Income Anchor

In addition to reducing a poorly priced risk by shortening duration, asset allocators may also be seeking to diversify that risk within the fixed-income anchor and across the portfolio. At first glance, credit does not fit the bill of a diversifier well. Over the last several decades and over the life of the high yield market, credit has been highly correlated to equities. However, the onset of higher-for-longer inflation prompts a reevaluation of credit’s relationship to equities and rates.

Intuitively, credit should perform well in a modestly high inflation environment, as the nominal debt of indebted companies stays fixed while earnings power can expand, leading to less real value of debt each year. Evidence of this intuition exists in recent performance of credit through a high inflation environment, including the historical evidence that higher inflation is associated with fewer defaults, and the negative correlation of investment-grade bonds to rate-sensitive Treasuries, both covered in these recent analyses, The Case for Credit, Part 1: The Resilience of High Yield Bonds and The Case for Credit, Part 2: The Asset Class as a Diversifier of Return Volatility.

Short-duration bonds also benefit from a long-standing behavioral anomaly in which credit-focused managers tend to spend more time and effort on longer-duration bonds, leaving the short-duration equivalents to outperform on a risk-adjusted basis because they are overlooked. A 25-year study of the Sharpe ratios of long-dated versus short-dated bonds is shown in Figure 7. This classic “low-risk” phenomenon has a well-known parallel in the equity market, whereby low-beta stocks have for decades outperformed high-beta stocks on a risk-adjusted basis.

Figure 7.

Sharpe ratios for indicated maturity and rating categories, January 1998–March 2024

Source: Bloomberg and Lord Abbett. Based on the Bloomberg U.S. Aggregate Bond Index. Past performance is not a reliable indicator or guarantee of future results. Sharpe ratio is calculated by taking an asset class’s (or portfolio’s) excess return above the risk-free rate and dividing it by the standard deviation of its returns. The greater the Sharpe ratio, the better the risk-adjusted performance has been. For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

Finally, credit’s role as a diversifier is bolstered by its dimensionality—meaning there are many facets to it such as consumer credit, corporate credit, real estate, asset backed—which allows for a credit-focused, active manager to achieve better diversification in credit than in a monolithic factor, such as interest rates.

Bringing the Recommendations Together: Short-Duration Credit in Fixed-Income Allocations

By combining the limited duration exposure with the diversification properties of credit, short-duration credit allocations can help anchor a fixed-income portfolio as the higher-for-longer regime shifts into focus for allocators. Figure 8 shows the risk and return properties of the Lord Abbett Short Duration Income Fund, the Lord Abbett Core Fixed Income Fund, and the Bloomberg U.S. Aggregate Bond Index over the last 15 years.

Figure 8.

Lord Abbett Short Duration Income Fund, Lord Abbett Core Fixed Income Fund, and the Bloomberg U.S. Aggregate Index, May 31, 2009–June 30, 2024

Expense Ratios:

Lord Abbett Short Duration Income Fund Class I shares 0.39%

Lord Abbett Core Fixed Income Fund Class I shares 0.36% gross, 0.32% net

Source: Morningstar and Bloomberg. Performance data quoted reflect past performance and are no guarantee of future results. Current performance may be higher or lower than the performance quoted. The investment return and principal value of an investment in the Fund will fluctuate so that shares, on any given day or when redeemed, may be worth more or less than their original cost. You can obtain performance data current to the most recent month-end by calling Lord Abbett at 888-522-2388 or referring to lordabbett.com. Based on total return at net asset value, including the reinvestment of dividends and capital gains, if any, but does not reflect deduction of any front-end sales charges which are not applicable for Class I Shares. Class I Shares are available only to institutional investors and certain others, including retirement plans. Returns for periods of less than one year are not annualized. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment. Please see “Important Information” for more performance and other disclosures.

The current flatness of both the yield and credit curves makes a strong case for a short-duration bias in tactical allocations. The potential for an extra approximately 100 basis points (bps) of yield in a short-duration credit mandate versus an Aggregate-based mandate, could mean up to 40 bps annually in expected return advantage in a portfolio allocated 40% to fixed income.

The prospect of an extended inflationary trend as well as the historical record of outperformance and diversification by short-duration credit mean the inclusion of short duration in fixed-income allocations should be a long-term, strategic imperative as well. If the yield curve were to steepen by 100 bps between the 2-year Treasury and the 10-year Treasury, it would still not be at historical levels of steepness. With six years of duration, that steepening could shave another 600 bps from forward returns on an Aggregate-based fixed-income solution compared to a short-duration solution. We believe the higher carry and the limited exposure to this risk of rising long-term rates makes short duration a compelling addition to strategic fixed income allocations.

LALDX

Class A

Short Duration Income Fund

The Lord Abbett Short Duration Income Fund seeks to deliver a high level of current income consistent with the preservation of capital. Learn more.

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LCRAX

Class A

Core Fixed Income Fund

The Lord Abbett Core Fixed Income Fund seeks to deliver current income and the opportunity for capital appreciation. View portfolio and performance info.

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Insight

Fear Not Fed Easing with Short-Duration High Yield Bonds

A U.S. Federal Reserve (Fed) easing may be likely. A look to prior easing cycles suggests normalization of the yield curve does little to dent the attractive risk-adjusted returns of the strategy.

About the Contributors

Joseph M. Graham, CFA

Senior Managing Director, Investment Strategist

Kristen Doyle, CFA

Head of U.S. Institutional Market Strategy

Important Information

A Note about Risk: The Core Fixed Income Fund is subject to the general risks associated with investing in fixed income securities, including market, credit, liquidity, and interest rate risk. The value of an investment in the Fund will change as interest rates fluctuate in response to market movements. When interest rates rise, the prices of debt securities are likely to decline, and when interest rates fall, the prices of debt securities tend to rise. The Fund may invest in Treasury Inflation Protected Securities and other inflation-indexed securities, which are subject to greater inflation rate and interest rate volatility. The Fund may invest in foreign or emerging market securities, which may be adversely affected by economic, political, or regulatory factors and subject to currency volatility and greater liquidity risk. The Fund may invest in derivatives, which are subject to greater liquidity, leverage, and counterparty risk. These factors can affect Fund performance.

A Note about Risk: The Short Duration Income Fund is subject to the general risks associated with investing in debt securities, including market, credit, liquidity, and interest rate risk. The value of an investment will change as interest rates fluctuate and in response to market movements. When interest rates fall, the prices of debt securities tend to rise, and when interest rates rise, the prices of debt securities are likely to decline. Debt securities are subject to credit risk, which is the risk that the issuer will fail to make timely payments of interest and principal to the Fund. The Fund may invest in high yield, lower-rated debt securities, sometimes called junk bonds and may involve greater risks than higher rated debt securities. These securities carry increased risks of price volatility, illiquidity, and the possibility of default in the timely payment of interest and principal. The Fund may invest in foreign or emerging market securities, which may be adversely affected by economic, political, or regulatory factors and subject to currency volatility and greater liquidity risk. The Fund may invest in derivatives, which are subject to greater liquidity, leverage, and counterparty risk. These factors can affect Fund performance. Past performance is no guarantee of future results.

Unless otherwise noted, all discussions are based on U.S. markets, U.S. monetary and fiscal policies, and U.S. dollar-denominated index and return data.

Asset allocation or diversification does not guarantee a profit or protect against loss in declining markets.

No investing strategy can overcome all market volatility or guarantee future results.

The value of investments and any income from them is not guaranteed and may fall as well as rise, and an investor may not get back the amount originally invested. Investment decisions should always be made based on an investor’s specific financial needs, objectives, goals, time horizon, and risk tolerance.

Market forecasts and projections are based on current market conditions and are subject to change without notice. Projections should not be considered a guarantee.

Equity Investing Risks

The value of investments in equity securities will fluctuate in response to general economic conditions and to changes in the prospects of companies and/or sectors in the economy. While growth stocks are subject to the daily ups and downs of the stock market, their long-term potential as well as their volatility can be substantial. Value investing involves the risk that the market may not recognize that securities are undervalued, and they may not appreciate as anticipated. Smaller companies tend to be more volatile and less liquid than larger companies. Small cap companies may also have more limited product lines, markets, or financial resources and typically experience a higher risk of failure than large cap companies.

Fixed-Income Investing Risks

The value of investments in fixed-income securities will change as interest rates fluctuate and in response to market movements. Generally, when interest rates rise, the prices of debt securities fall, and when interest rates fall, prices generally rise. High yield securities, sometimes called junk bonds, carry increased risks of price volatility, illiquidity, and the possibility of default in the timely payment of interest and principal. Bonds may also be subject to other types of risk, such as call, credit, liquidity, and general market risks. Longer-term debt securities are usually more sensitive to interest-rate changes; the longer the maturity of a security, the greater the effect a change in interest rates is likely to have on its price.

The credit quality of fixed-income securities in a portfolio is assigned by a nationally recognized statistical rating organization (NRSRO), such as Standard & Poor’s, Moody’s, or Fitch, as an indication of an issuer’s creditworthiness. Ratings range from ‘AAA’ (highest) to ‘D’ (lowest). Bonds rated ‘BBB’ or above are considered investment grade. Credit ratings ‘BB’ and below are lower-rated securities (junk bonds). High-yielding, non-investment-grade bonds (junk bonds) involve higher risks than investment-grade bonds. Adverse conditions may affect the issuer’s ability to pay interest and principal on these securities.

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Glossary & Index Definitions

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 U.S. Corporate Index covers publicly issued, investment-grade, U.S. corporate and specified foreign debentures and secured notes that meet the specified maturity, liquidity, and quality requirements. To qualify, bonds must be SEC-registered.

Bloomberg 1-3 Year Government/Credit Index is the 1-3-year maturity subset of the Bloomberg Government/Credit Index, which includes securities in the Government and Credit Indices. The Government Index includes treasuries (i.e., public obligations of the U.S. Treasury that have remaining maturities of more than one year) and agencies (i.e., publicly issued debt of U.S. Government agencies, quasi-federal corporations, and corporate or foreign debt guaranteed by the U.S. Government). The Credit Index includes publicly issued U.S. corporate and foreign debentures and secured notes that meet specified maturity, liquidity, and quality requirements.

ICE BofA 1-3 Year U.S. Corporate Bond Index is the 1–3-year maturity subset of the ICE BofA U.S. Corporate Bond Index. The ICE BofA US Corporate Index tracks the performance of US dollar denominated investment grade corporate debt publicly issued and settled in the US domestic market. Qualifying securities must have an investment grade rating (based on an average of Moody’s, S&P and Fitch), at least 18 months to final maturity at the time of issuance, at least one year remaining term to final maturity as of the rebalancing date, a fixed coupon schedule and a minimum amount outstanding of $250 million. Original issue zero coupon bonds, 144a securities (with and without registration rights), and pay-in-kind securities (including toggle notes) are included in the index.

Quantitative easing refers to a monetary policy action where a central bank purchases predetermined amounts of government bonds or other financial securities/assets in order to stimulate economic activity.

Hawkish monetary policy focuses on low inflation and may involve raising interest rates, while dovish policy prioritizes low unemployment and may involve lowering rates.

Treasuries are debt securities issued by the U.S. government and secured by its full faith and credit. Income from Treasury securities is exempt from state and local taxes. Although U.S. government securities are guaranteed as to payments of interest and principal, their market prices are not guaranteed and will fluctuate in response to market movements.

Excess returns are the return achieved by a security (or portfolio of securities) above the return of a benchmark. The risk-free rate (i.e., Treasuries) and benchmarks with similar levels of risk to the investment being analyzed are commonly used in calculating excess returns.

Real yield is the stated yield on a fixed-income investment minus the impact from inflation.

Information Ratio measures and compares the active return of an investment compared to a benchmark index relative to the volatility of the active return.

Spread is the percentage difference in current yields of various classes of fixed-income securities versus Treasury bonds or another benchmark bond measure. A bond spread is often expressed as a difference in percentage points or basis points (which equal one-one hundredth of a percentage point). The option-adjusted spread (OAS) is the measurement of the spread of a fixed-income security rate and the risk-free rate of return, which is adjusted to take into account an embedded option. Typically, an analyst uses the Treasury securities yield for the risk-free rate.

A basis point is one one-hundredth of a percentage point.

The Federal Reserve (Fed) is the central bank of the United States. The federal funds (fed funds) rate is the target interest rate set by the Fed at which commercial banks borrow and lend their excess reserves to each other overnight.

Yield curve is a line that plots the interest rates, at a set point in time, of bonds having equal credit quality, but differing maturity dates. The most frequently reported yield curve compares the three-month, two-year, five-year and 30-year U.S. Treasury debt. This yield curve is used as a benchmark for other debt in the market, such as mortgage rates or bank lending rates. The curve is also used to predict changes in economic output and growth.

Term premium is defined as the compensation that investors require for bearing the risk that interest rates may change over the life of a bond.

Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

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