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What can bond yields tell us about future returns?
15-year highs in yields offer an attractive entry point to fixed income investments. Flows, however, have been muted as investors take stock of negative returns in the asset class.
In our piece, we explore whether today’s yields can provide an insight into the trajectory of future returns. We make the case that, though spreads remain near historical averages, all-in yields today offer a compelling total return profile. In particular, we discuss:
How to measure yield: in our piece, we use a measure known as yield-to-worst (YTW) that accounts for the callability of bonds. YTW is a more conservative measure than the commonly used yield-to-maturity and expresses the annualised rate of return to the first opportunity that a bond could be redeemed.
Time horizons: returns in any given year can produce a distorted view of the relationship between returns and yields, so we consider longer time horizons, taking the Bloomberg US Aggregate Index (from 1976) and the European Aggregate Index (from 1998) and comparing their respective YTWs to their 5-year forward returns.
Trends: when looking at the relationship between yields and returns, two trends emerge. First, specific periods correlate with different yield and return environments, and second, the relationship between yields and returns is largely constant, with the exception of periods that coincide with a sustained upward shock to base rates (namely, 2021-2023 and 1976-1977).
The yield buffer: today the breakeven cushion offered by starting yields is much higher than last year. The yield on an index that can be achieved in any given year should help to cushion losses from defaults or rate rises. This coupon effect is most visible in higher carry asset classes, where total return is more a function of income return than price return1.
As a result, asset classes with relatively greater starting yields driven by the coupon component of yield, such as high yield, and even emerging markets local currency, can outperform the broader fixed income universe.
Today’s opportunity & active management
Today, higher yields offer the most compelling starting point in 15 years for fixed income investors. With yield returning to the asset class, investors can expect fixed income to deliver returns and not just diversification. While yields may creep higher still, today’s higher yields already offer a buffer against losses. Today, interest rates appear to have touched cycle highs as markets price cuts from here across most developed economies.
Given those conditions, there is a reasonable expectation that yields today offer a fair guide to returns going forward. Naturally, there are many factors that could reduce the efficacy of this relationship, such as credit quality, country risk, optionality, and convexity, but that is where we believe that careful active management will add the most value.
It is our view that, for investors willing to invest with a fixed income active manager, today’s starting yields offer a strong entry point from which to maximise the return potential of yields, through prudent selection and allocation of risk.
1. Total return from bonds can be disaggregated into income return and price return. The income return derives from the interest earned by holding the bond, while the price return derives from any change in the bond’s market price.
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