Key Takeaways From Our 2021 Advisor Fixed Income Portfolio Review

by Justin Blesy, Brian Kyle of PIMCO, 6/29/22

The first quarter of 2022 was the most volatile period for fixed income in decades, marked by sharp increases in interest rates and negative returns across fixed income allocations. It followed similar bouts of turbulence in 2021 and 2020.

While volatility can make it challenging for investors to remain disciplined, those with a long-term approach can potentially find compelling return opportunities. The reason? As yields rise, bond portfolios may suffer short-term losses, but future return potential adjusts higher. The challenge lies in building well-diversified portfolios and calibrating expectations to navigate volatility and realize those future returns.

In our 7th annual review of advisor fixed income portfolios we identify key themes from the 1,400 portfolios we analyzed in 2021 and share how PIMCO is positioning fixed income allocations amid high inflation and rising rates. Key themes include:

  • Clients continue to favor high quality duration complemented by more flexible and credit-oriented multi-sector strategies.
  • Higher starting yields and wider spreads bode well for future returns in both duration and credit-sensitive sectors.
  • With thoughtful portfolio construction, bonds can continue to provide key benefits, including income generation, equity diversification and capital preservation.

Putting 2022 into context

The bond market’s sell-off in the first quarter of 2022 was historic, with sharp increases in inflation and interest rates driving negative returns in both duration and credit-centric fixed income sectors. Yet the sell-off has resulted in much more attractive yields, boding well for future returns (see Figure 1).

In Figure 1, the left-hand chart is a line graph showing the Bloomberg U.S. Aggregate Bond Index’s five-year return starting from January 1976. The five-year forward return peaked at just above 20% in August 1981 and fell steadily to a low of 1.2% on 30 April 2017 with a 94% correlation to the index’s starting yield over that span. The chart shows the current yield rising from a low of 1.36% in July 2021 to 2.92% as of 31 March 2022. The table at the right shows the trailing three-year and forward five-year returns of the Bloomberg U.S. Corporate High Yield Excess Return Index based on the percentile rank of average spread levels. For example, in the 80th to 100th percentile category, the average spread was 869 basis points. The corresponding three-year trailing return was -5.03% and the three-year forward return was 8.30%. By contrast, in the zero to 20th percentile category, the average spread level was 291 basis points. The corresponding three-year trailing return was 5.29% and the three-year forward return was -2.94%. The time period used for the high yield returns is from December 1992 to 31 March 2022. Image Pop Up

Furthermore, strong future returns in fixed income have often historically followed poor trailing returns. Looking forward, higher starting yields present a potentially attractive entry point even though recent performance can make this seem intimidating.