Fixed Income: Addressing the Risk-Adjusted Versus Absolute Return Question

Download the PDF version of this insight

With the September 18 rate cut of 50 basis points by the U.S. Federal Reserve (Fed), we can officially declare the end of Act I for the movement of the U.S. Treasury yield curve, and history has largely repeated itself. But will the easing cycles of years past be a reliable predictor of yield curve change in Act II?

Part of that answer will depend on the economic cycle and the length and depth of a U.S. recession, if one is entered. But there is also an underlying regime characterized by small term premium and flat yield curves, and consideration of these factors will be important in decision-making for risk-adjusted versus absolute returns, as well as strategic and tactical asset allocation.

The Market Impact of Fed Rate Cuts

We’ve previously shared Figure 1, regarding the movement of Treasury yields in the six months prior to, and six months after, the first rate cut of an easing cycle; the change in yields are average changes observed over the last four easing cycles. We’ve overlaid the yield change of Treasury yields for the six months ended September 18, 2024, and as we can observe, the pattern has remained the same.

Figure 1. Tracking the Path of U.S. Treasury Yields Before, and After, Initial Fed Rate Cuts

Source: Bloomberg. Chart depicts average path of yields for U.S. Treasury securities of stated maturities six months before, and six months after, the first cut in the fed funds rate in tightening cycles that began in 1995, 2001, 2007, 2019, and in the six months preceding the Fed cut on September 18, 2024.
Past performance is not a guarantee of future results. 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.

Each easing cycle is, of course, different given the market and economic environment at hand. The previous easing cycles would suggest a continued steepening of the two- to 10-year Treasury curve, and this outcome would be more likely with a recession. But in the scenario of an economic “soft landing,” we would suggest continued flatness in the yield curve slope.

Act II: Steeper Like Before

As mentioned, on average, there has been a noticeable steepening between two- and 10-year Treasuries in the six months following the first rate cut of an easing cycle, and there certainly exists a scenario where a similar outcome will be experienced in 2024–25. The interpretation of the level of the 10-year Treasury yield can vary, but from a historical perspective, one of the most common and logical interpretations is that the risk-free rate of the 10-year Treasury investment should approximate (and for which the investor should be compensated) the level of real (inflation-adjusted) economic growth—plus some expectation of inflation and some term premium to represent uncertainty.

When the Fed is implementing an aggressive easing policy, a steeper curve should be expected. First, the two-year Treasury is a representation of short-term rates and more correlated to the direction and level of the fed funds rate, which creates downward pressure on two-year yields; and second, the easing of financial conditions creates an intermediate anticipation of potential higher real growth, higher inflation expectations, and greater uncertainty (term premium) therein, which causes the upward pressure on 10-year Treasury yields.

So, what would it take for the Fed to implement an aggressive easing policy in 2024–25? We feel that would be a recession with the condition that inflation has moderated, and the Fed and the markets have a high conviction that the central bank’s mandate of “stable prices” has been or will imminently be satisfied. Looking at the average yield curve slope from two- to 10-year Treasuries for the last four recessions (Figure 2), we can see that an upward slope is reliable, and over the four recessions, the slope averaged +108 bps.

Figure 2. Tracking the Slope of the Yield Curve in Past U.S. Recessions

Source: Bloomberg. Bps = basis points; one basis point is equal to one one-hundredth of a percentage point. For illustrative purposes only.

Act II: Different from the Past

On October 11, 2001, Fed Chair Alan Greenspan gave remarks on “Transparency in monetary policy” at a conference in St. Louis, and there are two excerpts from that speech which we believe are relevant for this writing. The first, citing a decades-old debate on market uncertainty and its impact on short-term debt markets: “As markets, experience, and the magnitude of outstanding financial instruments changed, the dead-weight loss created by such uncertainty became increasingly evident, as did the value of transparency.”

We previously mentioned one interpretation of the level of the 10-year Treasury yield to support yield curve slope movement during an easing cycle. Another interpretation, according to the Federal Reserve Bank of New York, is that “yields on Treasury securities are composed of two components: expectations of the future path of short-term Treasury yields and the Treasury term premium. The term premium is defined as the compensation that investors require for bearing the risk that interest rates may change over the life of the bond.”

Figure 3 shows the estimated term premium for the 10-year Treasury since mid-1961, and it is observable that term premium has been much lower as of late. It is largely an arbitrary date since it’s difficult to exactly pinpoint the date of a regime change, but using October 11, 2001, as the point of demarcation: the average term premium for the 10-year Treasury after said date is -9 bps while before the date, the average is +187 bps. Was there indeed a regime shift? Perhaps a definitive answer can’t be given until a few more economic cycles are experienced, but simply asked via hyperbole: Why should an investor be compensated for changes in interest rates when the Fed is committed to full transparency of monetary policy and the potential future path of short-term Treasury yields?

Figure 3. Term Premium Has Been Declining

Estimated term premium on 10-year U.S. Treasury debt, July 1962–August 2024

Source: Bloomberg and Lord Abbett. Data as of August 31, 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. Term premia are estimated, most often from financial and macroeconomic variables.
Past performance is not a reliable indicator or guarantee of future results. 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 and expenses, and are not available for direct investment.

Case in point, the most recent “dot-plot” projection¹ revealed at the September 18, 2024, meeting of the Federal Open Market Committee, the Fed’s policy-setting arm, suggests the FOMC voting members believe the long-run neutral fed funds rate is in a range between 2.375% and 3.75%, and the median observation is 2.875%. This brings us to the second of Greenspan’s remarks on transparency from the 2001 speech cited earlier: “By price stability, however, I do not refer to a single number as measured by a particular price index. In fact, it has become increasingly difficult to pin down the notion of what constitutes a stable general price level.”

Since Chairman Greenspan’s remarks, the world has changed, and we now have an average inflation target of 2%, but this is a target over the long term, and we feel it’s reasonable that we will find periods when price stability can be found at higher (or lower) rates of inflation, while achieving the dual mandate (price stability, as mentioned earlier, and full employment). And currently, the unique status of the U.S. housing market, defined by an extreme supply/demand imbalance, could cause shelter inflation, and inflation measures in general, to remain elevated for an extended period.

But, in this scenario where the Fed can provide policy accommodation to engineer a soft landing, while remaining confident in having achieved price stability (and not a predetermined rate of inflation), then the yield curve can represent the market’s interpretation of the neutral fed funds rate across maturities with little term premium. In other words, given current expectations of the neutral rate, the forward six-month experience of Treasury yields should be a decline with a parallel movement across maturities, including two- and 10-year.

Act II: The One No One Sees Coming

Since we’ve covered yield curve movements of steepening and parallel shift, we should mention a flattening or reinversion of the yield curve for completeness. The most likely conditions to drive this movement would include:

Reacceleration of inflation
Fed prioritizing the battle against inflation
Continued restrictive monetary policy
Expectation or realization of declining labor and economic fundamentals, and a U.S. recession

Return Is in the Eye of the Beholder

So, on to the question of absolute or risk-adjusted return cited at the beginning of the piece. In Figure 3, we display the characteristics of short- and intermediate-term Bloomberg U.S. Government/Credit indexes, including yield and duration. The standard deviation of returns for these indexes is also shown for the last one, five, and 10 years. Let’s consider the potential for outcomes in the above scenarios through the lens of interest rates and credit to address the risk-adjusted versus absolute return question.

Figure 3. At the Start of a New Rate-Cut Cycle, Some Key Comparisons for Short- and Intermediate-Term Bonds

Source: Bloomberg.
Duration is a measure of the sensitivity of the price (the value of principal) of a fixed-income investment to a change in interest rates.
Standard deviation is a statistic that measures the dispersion of a data set relative to its mean. The higher the standard deviation, the further the observed data are from the mean.
Past performance is not a reliable indicator or guarantee of future results. 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 and expenses, and are not available for direct investment.

To begin, given the relative flatness of the yield curve currently and the subsequent similarity in current yield for the provided indexes, a short-duration strategy will more often than not provide a better risk-adjusted experience. As shown, the standard deviation of historical returns for the intermediate government/credit index is approximately four times that of the shorter-duration counterpart.

In a curve-steepening scenario, an exposure to credit risk will likely benefit over a longer horizon, as an easing cycle creates expectations of an economic upturn/recovery and a pricing of risk on expected stronger fundamentals. A shorter-duration strategy will absolutely have the better risk-adjusted return given the steepening environment, but the absolute return question is more difficult to answer. This will depend upon the type of yield curve steepening, and how each maturity of the yield curve changes in level.

In a scenario of a flat yield curve that is moving in parallel fashion, a shorter-duration strategy will again have a better risk-adjusted return given starting yields. The decline in Treasury yields that would be required to drive such a higher return in an intermediate strategy to offset the much higher historical return volatility is logically unattainable. But, in an absolute return sense, the power of duration in a declining yield environment makes intermediate duration an obvious allocation, in our view; and in this environment, defined by a soft landing and a Fed gradually moving toward a neutral rate, credit risk will offer advantages as well.

And last, in the scenario that no one sees coming, both risk-adjusted and absolute returns being more favorable in an intermediate-duration strategy is a reasonable outcome, especially with a strategy that is higher in credit quality.

So, strategic and tactical decisions abound over these next six months, and allocation choices, of course, depend upon the eye of the beholder. But we think history has provided us with some useful insights to help inform those choices.

Insight

Investment Brief: Addressing Key Questions on CLOs

As investor interest in collateralized loan obligations grows, we examine the important characteristics of the asset class—and its relevance for investors.

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.

Learn More

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.

Learn More

About the Author

Kewjin Yuoh

Partner, Portfolio Manager

Kewjin Yuoh is responsible for contributing to the management for the firm’s taxable-fixed income strategies with a multi-sector focus on investment grade assets.

¹Economic projections are collected from each member of the Fed’s Board of Governors and each Federal Reserve Bank president four times a year, in connection with the Federal Open Market Committee's (FOMC's) meetings in March, June, September, and December. The charts and tables associated with those projections are released shortly following the end of an FOMC meeting.

Important Information

Unless otherwise noted, all discussions are based on U.S. markets and U.S. monetary and fiscal policies.

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 are 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.

This material may contain assumptions that are “forward-looking statements,” which are based on certain assumptions of future events. Actual events are difficult to predict and may differ from those assumed. There can be no assurance that forward-looking statements will materialize or that actual returns or results will not be materially different from those described here.

The views and opinions expressed are as of the date of publication, and do not necessarily represent the views of the firm as a whole. Any such views are subject to change at any time based upon market or other conditions and Lord Abbett disclaims any responsibility to update such views. Lord Abbett cannot be responsible for any direct or incidental loss incurred by applying any of the information offered.

This material is provided for general and educational purposes only. It is not intended as an offer or solicitation for the purchase or sale of any financial instrument, or any Lord Abbett product or strategy. References to specific asset classes and financial markets are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations or investment advice.

Certain information contained herein has been obtained from third party sources and such information has not been independently verified by Lord Abbett. No representation, warranty, or undertaking, expressed or implied, is given to the accuracy or completeness of such information by Lord Abbett or any other person. While such sources are believed to be reliable, Lord Abbett does not assume any responsibility for the accuracy or completeness of such information. Lord Abbett does not undertake any obligation to update the information contained herein as of any future date.

Please consult your investment professional for additional information concerning your specific situation.

Glossary & Index Definitions

Absolute return measures an investment's overall return, regardless of the market conditions that may or may not have affected it. A risk-adjusted return is a calculation of the profit or potential profit from an investment that considers the degree of risk that must be accepted to achieve it. The risk is measured in comparison to that of a virtually risk-free investment—usually U.S. Treasuries.

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

The Federal Reserve System (Fed) is the central bank of the United States and is governed by the Federal Reserve Board. The Federal Open Market Committee (FOMC), the policy-setting arm of the U.S. Federal Reserve, issues projections of the rate of U.S. economic growth at the conclusion of its meetings in March, June, September, and December of each year.

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.

Duration is a measure of the sensitivity of the price (the value of principal) of a fixed-income investment to a change in interest rates.

The neutral rate of interest, also known as r-star, is the real short-term interest rate expected to prevail when an economy is at full strength and inflation is stable.

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.

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. Term premia are estimated, most often from financial and macroeconomic variables.

Yield is the income returned on an investment, such as the interest received from holding a security. The yield is usually expressed as an annual percentage rate based on the investment's cost, current market value, or face value. Yield-to-worst refers to the lesser of a bond’s (a) yield-to-maturity or (b) the lowest yield-to-call calculated on each scheduled call date.

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. One such comparison involves the two-year and 10-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.

The Bloomberg U.S. Government/Credit Bond Index is an unmanaged index that is designed to represent a combination of the Government Bond Index and the Corporate Bond Index and includes U.S. government Treasury and agency securities, corporate bonds, and Yankee bonds. The Bloomberg U.S. 1-3 Year Government/Credit Bond Index and Bloomberg U.S. 5-10 Year Government/Credit Bond Index are maturity-specific subsets of the Bloomberg U.S. Government/Credit Bond Index.

Bloomberg Index Information

Source: Bloomberg Index Services Limited. BLOOMBERG® is a trademark and service mark of Bloomberg Finance L.P. and its affiliates (collectively “Bloomberg”). Bloomberg owns all proprietary rights in the Bloomberg Indices. Bloomberg does not approve or endorse this material or guarantee the accuracy or completeness of any information herein, or make any warranty, express or implied, as to the results to be obtained therefrom and, to the maximum extent allowed by law, shall not have any liability or responsibility for injury or damages arising in connection therewith.

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

Important Information for U.S. Investors

Lord Abbett mutual funds are distributed by Lord Abbett Distributor LLC.

FOR MORE INFORMATION ON ANY LORD ABBETT FUNDS, CONTACT YOUR INVESTMENT PROFESSIONAL OR LORD ABBETT DISTRIBUTOR LLC AT 888-522-2388, OR VISIT US AT LORDABBETT.COM FOR A PROSPECTUS, WHICH CONTAINS IMPORTANT INFORMATION ABOUT A FUND'S INVESTMENT GOALS, SALES CHARGES, EXPENSES AND RISKS THAT AN INVESTOR SHOULD CONSIDER AND READ CAREFULLY BEFORE INVESTING.

The information provided is not directed at any investor or category of investors and is provided solely as general information about Lord Abbett’s products and services and to otherwise provide general investment education. None of the information provided should be regarded as a suggestion to engage in or refrain from any investment-related course of action as neither Lord Abbett nor its affiliates are undertaking to provide impartial investment advice, act as an impartial adviser, or give advice in a fiduciary capacity. If you are an individual retirement investor, contact your financial advisor or other fiduciary about whether any given investment idea, strategy, product or service may be appropriate for your circumstances.

Important Information for non-U.S. Investors

Note to Switzerland Investors: In Switzerland, the Representative is ACOLIN Fund Services AG, Leutschenbachstrasse 50, CH-8050 Zurich, whilst the Paying Agent is Bank Vontobel Ltd., Gotthardstrasse 43, CH- 8022 Zurich. The prospectus, the key information documents or the key investor information documents, the instrument of incorporation, as well as the annual and semi-annual reports may be obtained free of charge from the representative. In respect of the units offered in Switzerland, the place of performance is at the registered office of the representative. The place of jurisdiction shall be at the registered office of the representative or at the registered office or domicile of the investor.

Note to European Investors: This communication is issued in the United Kingdom and distributed throughout the European Union by Lord Abbett (Ireland) Limited, UK Branch and throughout the United Kingdom by Lord Abbett (UK) Ltd. Both Lord Abbett (Ireland) Limited, UK Branch and Lord Abbett (UK) Ltd are authorized and regulated by the Financial Conduct Authority.

A decision may be taken at any time to terminate the arrangements made for the marketing of the Fund in any EEA Member State in which it is currently marketed. In such circumstances, Shareholders in the affected EEA Member State will be notified of this decision and will be provided with the opportunity to redeem their shareholding in the Fund free of any charges or deductions for at least 30 working days from the date of such notification.

Lord Abbett (Middle East) Limited is authorised and regulated by the Dubai Financial Services Authority (“DFSA”). The entire content of this document is subject to copyright with all rights reserved. This research and the information contained herein may not be reproduced, distributed or transmitted in any jurisdiction or to any other person or incorporated in any way into another document or other material without our prior written consent. This document is directed at Professional Clients and not Retail Clients. Any other persons in receipt of this document must not rely upon or otherwise act upon it. This document is provided for informational purposes only. Nothing in this document should be construed as a solicitation or offer, or recommendation, to acquire or dispose of any investment or to engage in any other transaction. Nothing contained in this document constitutes an investment, an offer to invest, legal, tax or other advice or guidance and should be disregarded when considering or making investment decisions.

Note to Singapore Investors: Lord Abbett Global Funds I plc (the “Company”) and the offer of shares of each sub-fund of the Company do not relate to a collective investment scheme which is authorized under Section 286 of the Securities and Futures Act, Ch. 289 of Singapore (“SFA”) or recognized under Section 287 of the SFA, and shares in each sub-fund of the Company are not allowed to be offered to the retail public. Pursuant to Section 305 of the SFA, read in conjunction with Regulation 32 of and the Sixth Schedule to the Securities and Futures (Offers of Investments) (Collective Investment Schemes) Regulations 2005 (the “Regulations”), the Lord Abbett Global Multi-Sector Bond Fund, the Lord Abbett High Yield Fund, the Lord Abbett Short Duration Income Fund, the Lord Abbett Ultra Short Bond Fund, the Lord Abbett Climate Focused Bond Fund, the Lord Abbett Emerging Markets Corporate Debt Fund and the Lord Abbett Multi Sector Income Fund have been entered into the list of restricted schemes maintained by the Monetary Authority of Singapore for the purposes of the offer of shares in such sub-funds made or intended to be made to relevant persons (as defined in section 305(5) of the SFA), or, the offer of shares in such sub-funds made or intended to be made in accordance with the conditions of section 305(2) of the SFA. These materials do not constitute an offer or solicitation by anyone in Singapore or any jurisdiction in which such an offer or solicitation is not authorized or to any person to whom it is unlawful to make such an offer or solicitation.

Note to Hong Kong Investors: The contents of this material have not been reviewed nor endorsed by any regulatory authority in Hong Kong. An investment in the Fund may not be suitable for everyone. If you are in any doubt about the contents of this material, you should consult your stockbroker, bank manager, solicitor, accountant or other financial adviser for independent professional advice. The Fund is not authorised by the Securities and Futures Commission ("SFC") in Hong Kong pursuant to Section 104 of the Securities and Futures Ordinance (Cap 571, Laws of Hong Kong) ("SFO"). This material has not been approved by the SFC in Hong Kong, nor has a copy of it been registered with the Registrar of Companies in Hong Kong and, must not, therefore, be issued, or possessed for the purpose of issue, to persons in Hong Kong other than (1) professional investors within the meaning of the SFO (including professional investors as defined by the Securities and Futures (Professional Investors) Rules); or (2) in circumstances which do not constitute an offer to the public for the purposes of the Companies (Winding Up and Miscellaneous Provisions) Ordinance (Cap 32, Laws of Hong Kong) or the SFO. This material is distributed on a confidential basis and may not be reproduced in any form or transmitted to any person other than the person to whom it is addressed.