Higher Bond Yields Can Be Fundamental to a Recession Investing Playbook

Investors who have already endured one of the most challenging years ever must now confront the question of how to invest when the U.S. and other major economies may be headed toward a recession. While financial market volatility is likely to persist, we believe the case for bonds is stronger than it has been in years, bolstered by significantly higher starting yields and bonds’ strong track record during economic downturns.

Bond yields have risen sharply in 2022 as the U.S. Federal Reserve and other central banks have hiked interest rates in an effort to tame inflation. Historically, starting yields have had a powerful correlation with bond returns, and today’s yields may offer investors both improved opportunities for income generation as well as greater downside cushion. The especially pronounced rise in shorter-dated bond yields means investors can find attractive coupons without taking on the greater interest rate risk inherent in longer-duration bonds.

Amid the current environment of inflation uncertainty, geopolitical risk, and potential economic contraction, we explore some reasons why bonds could offer better value compared with equities or cash.

1) Recession appears likely

A recession involves a significant, widespread decline in economic activity that lasts more than a few months, according to the National Bureau of Economic Research. Recessions are typically characterized by decreases in productivity, business profitability, and spending by both businesses and consumers, with the latter notable given consumer spending accounts for more than two-thirds of U.S. gross domestic product (GDP), according to Fed data. (For details, please see our recent publication, “Recessions: What Investors Need to Know.”)

As the Fed, the European Central Bank, and the Bank of England continue to pursue contractionary monetary policy, we now view a shallow, mild-to-moderate recession as our base case in the U.S. and other large developed markets such as the euro area and the U.K. There is risk that these downturns could be steeper.

The first half of a recession is typically marked by a decline in economic activity from a late-cycle peak. During this phase, core bond returns (i.e., U.S. Treasuries and investment grade securities) have historically been positive, while returns for high yield bonds, equities, and commodities have typically been negative (see Figure 1).

Figure 1 shows that recessionary periods have affected asset classes differently, with some outperforming others. The first half of a recession (shown on the right) is typically marked by a decrease in economic activity from its late cycle stage “peak”, as measured by analyzing growth, inflation and unemployment data. During the first half of a recession stage, core bond returns (i.e., Treasuries and investment-grade securities) are historically positive, while returns for high yield bonds, equities, and commodities are negative. The second half of a recession (shown on the left) is typically marked by a continued drop in economic activity – in which equities, high yield bonds, and core bonds historically perform well, and commodities decline – before the economy enters “recovery” or expansion stage (middle of chart).Image Pop Up

2) Outlook for equities is uncertain

Following losses in 2022, major stock indices may face further difficulties into next year if early recessionary headwinds gather force, as illustrated in the chart above. Continued concerns about inflation, and whether policy tightening may lead to or accelerate a downturn, could challenge equity markets in the coming months, with potential downside risks to corporate earnings estimates and margin expectations. We still see downside risk to the S&P 500 and other key equity indices from current levels (for more on our views on equities, see our latest Asset Allocation Outlook,Risk-Off, Yield-On”).