Since the beginning of March 2018, as a result of “monetary normalization” -gradual official rate increases- that the Federal Reserve began at the end of 2015, we echoed the possibility of buying both Treasury bonds and long-term corporate bonds from US issuers -between ten and thirty-year maturities-. The reason for this conclusion was based on our forecasts that these increases in official rates would end up having a negative impact on economic activity not only in the US but also on a global level. On this occasion we would like to analyze the possibility of investing, with an eye to the future, to take advantage of forthcoming opportunities in dollar fixed-income.

As we can see in chart 1 below, our forecasts were accurate, economic activity indices both in the US and in the rest of the world have plummeted and as a consequence, the annual return offered by the 10Y US Treasury bond has fallen from the 3.2% it reached in October 2018, down to 1.5%. This has allowed investors to obtain returns in the year to date of between 10% and 30%, depending on the average maturity of the bonds in their portfolio.

Chart 1. US economic activity index (ISM Manufacturing) vs Annual return offered by the 10Y Treasury bond

1. How to invest in dollar fixed-income today

At this point, and considering that:

1. The annual return provided by US treasury bonds has fallen sharply, as a result of which the Federal Reserve has cut official rates on two occasions in the current year and the market has discounted two further cuts before the end of the year, to combat the economic slowdown mentioned earlier.
2. The annual return from corporate bonds of low credit quality (high yield) on US Treasury bonds, “credit spreads” are at historically low levels, given the current circumstances of the economic slowdown.

The alternative, given this situation, could be to invest in a well-diversified bond portfolio or in a bond fund that maximizes the annual return currently offered (via coupon), against their risk measured as annual volatility. Such a portfolio could be composed of the following assets:

• US short-term corporate bonds with high credit ratings, maturities between 1-3 years.
• US medium-term corporate bonds with good credit rating, maturities between 5-7 years.
• US short-term high-yield corporate bonds, maturities between 1-3 years.

Investing in this way, as we can see in chart 2 below, we would obtain the maximum annual return via coupon collection (around 2.5% -3%) for each unit of risk assumed.

Chart 2. Annual return offered (via coupon) for US fixed-income assets and risk (volatility)

2. How to take advantage of future fixed-income opportunities

Currently, according to the New York Fed’s recession indicator based on the slope of the US Treasury bonds yield curve, the likelihood that the US economy will go into recession in the next twelve months is around 40%. As a result, we still do not have the certainty that this event will actually occur, however, if it does occur, we have made an estimate in chart 3 below of the total return of the various US fixed-income assets on a 20M horizon, as well as the annual return via coupon (IRR) that they would offer at that time.

Chart 3. Own estimate of the total cumulative return by the various US fixed-income assets and IRR offered to July 2021 if there is a recession in the US

As we can see, an investor who was invested today in the assets referred to above, could divest themselves of their portfolio, without suffering any wealth erosion, and invest in US fixed-income assets which would have a much higher potential return in the coming years, that is:

• A portfolio of US short-term corporate bonds with a high credit rating could be exchanged for a well-diversified portfolio of US short-term high-yield corporate bonds, with the associated IRR rising from 1.6% to 8.5% over the same term.
• A portfolio of US medium-term corporate bonds with a good credit rating could be exchanged for a well-diversified portfolio of US long-term corporate bonds with adequate credit quality (BBB), with the associated IRR rising from 3.5% to 4.5% over a longer-term (10 years).
• A portfolio of US short-term high-yield corporate bonds could be exchanged for a portfolio of US medium-term high-yield corporate bonds, with the associated IRR rising to 9% over a longer-term (6 years).

 

Conclusions

Everything seems to indicate that the most interesting option would be to be invested in US fixed-income assets which offer an attractive annual return (2.5% -3%) with low risk, so as to be able to invest at much higher annual returns (6% -8%) if there is a recession in the US without having suffered any wealth erosion along the way.

However, if you want more information or have any questions, do not hesitate to contact your investment manager.