Posted by Lawrence Gillum, CFA, Fixed Income Strategist
Tuesday, May 10, 2022
The unrelenting move higher in U.S. Treasury yields continued last week with the yield on the 10-year Treasury up another 15 basis points (0.15%). Moreover, 10-year Treasury yields have doubled this this year with 130 basis points (1.3%) of that 150 basis point increase in yields coming since March 3. Last week’s increase in the 10-year Treasury yield was the 14th week (out of the last 18 weeks) where yields ended the week higher. To say it’s been a challenging year for fixed income markets is a huge understatement.
“The opportunity set for core bonds has improved greatly this year,” noted LPL Financial Fixed Income Strategist Lawrence Gillum. “Core bonds, in general, have been pretty expensive over the past few years but are much more attractive at current levels. The universe is trading at deep discounts to par so the potential for price appreciation is the highest it’s been in decades.”
However, fixed income instruments are fundamentally different than other financial instruments. Bonds are not only tradable securities but are also financial obligations where the issuer is contractually obligated to return principal at or near par at the maturity of the bond. That is, if an investor holds a bond (or a portfolio of individual bonds) to maturity, bond issuers are obligated to pay back par, regardless of the interest rate and inflationary environment. So, while this year has certainly been challenging, we do think the investment landscape has improved as current prices for many fixed income securities are trading at deep discounts to par.
As shown in the LPL Chart of the Day, the average price of a bond within the Bloomberg Aggregate bond index is less than $93, which is the largest discount to $100 par price in more than four decades. And while it is more common for non-investment-grade rated securities to trade at such deep discounts to par due to the higher probability of default, these are high quality securities with an investment-grade rating and with low expected default rates. Currently, nearly 82% of the universe of core bonds trade below par. Moreover, the average price of a U.S. Treasury security within the Aggregate index is $92.29—and it is a near certainty that the U.S. government will honor its financial obligations and pay back its debt at par.
Over the long run, the contribution to the total return for most fixed income investments depends more on coupon income than on changes in price. Since 1976, just over 90% of the average annual return of the U.S. bond market has come from interest payments and the reinvestment of interest payments. The big price moves we’ve seen this year are certainly unusual but may present an opportunity for price appreciation along with common interest payments.
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