U.S. bonds have been under a lot of stress this year, with prices falling and yields rising. With the Federal Reserve raising interest rates in order to stay on its policy-tightening path, Treasuries have seen bouts of selling that have propelled yields higher. Consider that the 2-year Treasury yield hit 4.67% recently, its highest level since 2007, and the benchmark 10-year yield pierced 4%, its highest since 2010.
Various global developments, especially related to currencies, have added to frayed nerves around the world. For instance, Japan recently stepped in to shore up the yen, while maintaining ultralow interest rates, after the currency tumbled to a 24-year low against the U.S. dollar. In the U.K., surprise fiscal policy stimulus, including tax cuts that were later partly reversed, was viewed as running counter to the Bank of England’s monetary tightening, igniting a selloff in global sovereign debt markets and sending the pound to an all-time low against the U.S. dollar last week.
Such events have helped drive the bond-market volatility gauge, known as the MOVE Index, to the second-highest reading in its history, bested only by peaks during the 2008 global financial crisis. The latest moves may be pushing bonds closer to a bear-market bottom. In addition to short-term Treasuries offering decent yields, we see a particular opportunity in short-duration, U.S. investment-grade corporate bonds for the following reasons:
- 2-year Treasury yield at 4.67%, are the highest they’ve been in a decade.
- Duration, a measure of a bond’s sensitivity to changes in interest rates, is relatively low for the short-term segment of investment-grade bonds, at about 2.6. This means these bonds may be less sensitive to incrementally higher rates, especially if the Fed raises rates beyond market expectations.
- Credit quality is generally solid. The interest coverage ratio, a figure showing how capable a company is of paying interest on its outstanding debt, is currently 12.6, its best level since the early 1990s, and has been trending higher over the last two quarters.
- Overall gross leverage, a measure of companies’ indebtedness, is also reasonable at 2.3, well below the COVID-era peak of 2.9 in the second quarter of 2020 and slightly below the 2009-2019 average of 2.4.
- Lastly, many investment-grade debt issuers have already locked in historically low rates, and additional refinancing activity is expected to be modest for the next 18 months.
We should note that the “bottoming process” of a bear market can play out differently for bonds and stocks. Usually, in a policy-driven cyclical bear market, like the current one, stocks go through two phases: first, an adjustment of valuation multiples, which we believe we have seen, and next a downgrading of earnings, which is underway. Bonds, by contrast, typically have a more linear process, in which interest rates rapidly adjust to their ultimate destination. These dynamics suggest to us that bonds may be closer to a bottom than equities.
In this environment, we reiterate the potentially stronger risk/reward profile offered by short-duration, investment-grade bonds. Investors should consider locking in solid yields over the near term as we wait out the stock market’s roller coaster.