Back To Basics: Remembering The ‘Income’ In Fixed Income

Andrii Yalanskyi By Jennifer Schnabl As we approach Q4, the fixed income markets are taking stock of where they’ve been and what is to come. Markets are expecting a highly anticipated shift in monetary policy to take place before the end of the year, which would mark a turning point in one of the most aggressive interest rate hiking cycles the U.S. has seen. Until now, most fixed income segments have weathered the volatility in the rate market, turning in varied performance on a YTD basis. Although “higher for longer” currently feels more like “higher for not much longer,” historically high yields across fixed income assets remain for the time being. Finance textbooks remind us of the traditional role that fixed income plays in a typical portfolio. First, fixed income provides diversification from other asset classes, like equities. Second, fixed income provides a source of capital preservation, in that the principal amount is expected to be returned at a scheduled maturity date. And third, as implied in the name “fixed income,” there is an expectation of predictable income associated with bonds via a fixed coupon. This predictability or “fixed” nature can play an important role for investors as they plan their future income needs. As fixed income yields are forward-looking, it is important to highlight the historically high levels of yields across most areas of fixed income, particularly as we approach a potential pivot in rate policy. A snapshot of the environment prior to the Fed’s rate hiking cycle, which commenced in 2022, shows that yields – as measured by our broad range of fixed income indices – were at some of their lowest levels in decades, a reminder of the potential income associated with a low-rate regime. Today’s picture not only offers some of the highest yields in decades, but a more convergent picture across fixed income, in which the differences between asset classes are smaller than those of the past. While fixed income yields are heavily intertwined with the level of overnight rates, as determined by the U.S. Federal Reserve, it is notable to observe the timing and nature of this relationship over time. The broad-based U.S. Treasury yield, as measured by the iBoxx USD Treasuries Index, has historically moved closely in line with the daily Fed funds rate. It has also reacted along with, and often times prior to, an announcement of a change in the Fed funds rate. U.S. investment grade yields, as measured by the iBoxx USD Investment Grade Index, have behaved in a similar fashion; however, given the credit component, there are additional factors that drive their movements. Another aspect at play in the current environment is the shape of the interest rate curve, and how that has affected investor positioning. An inverted yield curve environment in U.S. rates emerged in 2022 and has persisted since, although there have been moments of flattening in 2024. As such, yields at the shorter end of the curve have been higher than the longer end of the curve. This, coupled with the interest rate volatility the market has weathered since Fed policy was put on hold in 2023, has made the front end a common place for portfolio allocation. However, this positioning may change as the yield profiles along the curve change, extending duration to track today’s yields. Based on historical occurrences, if the anticipated lowering of policy rates takes shape, and the curve normalizes, some positions may move from the front end to further out the curve.