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Income in the new macro regime

Wed 24 May 2023

Income is back as a portfolio driver as we see interest rates staying high in the new regime of macro and market volatility.

We like bonds for income even if we don’t expect them to offset risk-asset slides as much as they did in the past – or gain in price from falling yields. We favour very short-term, high-quality government paper and emerging market (EM) local currency debt. We also see value in high-quality credit as we keep risk low on a six- to 12-month tactical horizon.

Yield is back

Fixed income indexes yielding over 4%, 1999-2023

Source: BlackRock Investment Institute, April 2023. Notes: The bars show market capitalization weights of indexes with an average annual yield over 4% in a select universe representing about 70% of the Bloomberg Mulitiverse Bond Index. Euro Core is based on French and German indexes. Euro periphery is based on Italy, Spain and Ireland. Emerging markets combine external and local currency debt. Current calendar year data is not averaged and reflects month-end yield.


Yield is back: The share of fixed-income indexes yielding over 4% is at its highest level since 2008 (see the chart). Global investment grade (IG) credit has come roaring back after a long drought (dark orange bars). We like income in bonds as a result. We also like that we can earn decent income from high-quality bonds without reaching into riskier parts of fixed income or even equities for dividends. We favour income in these bonds but don’t think they’ll play the ballast role of the past in portfolios. Policy rates used to fall quickly as an economic downturn struck, pushing yields lower – but we think sticky inflation makes that unlikely. That’s why we think long-term government bonds’ ability to offset selloffs in risk assets will be less now: We don’t see major central banks coming to the rescue of the economy with rate cuts this year. We see the Federal Reserve and European Central Bank hiking rates again this week even as growth takes a hit.

Leaning into income

In the new macro regime of heightened growth and inflation volatility, we like bonds for income rather than earning returns from falling yields or using them as a portfolio ballast.

We’re tactically overweight very short-term, high-quality government paper. Income is attractive, with limited credit and duration risk – or sensitivity to interest rate swings. Yet risks over raising the U.S. borrowing cap loom, with a deadline that could come sooner than initially expected as tax revenue comes in. We think a resolution will ultimately be reached. We see only a temporary rise in selected Treasury bill yields as the date nears when the U.S. Treasury might run into trouble making payments or need to prioritize debt payments over other obligations. Still, we could see market volatility and risk assets come under pressure as in past episodes. We remain modestly underweight U.S. stocks.

We think investment-grade credit offers good income, with yields around 5% globally. We’re tactically overweight European investment grade and prefer it to U.S. peers given more attractive valuations and its shorter duration. We put our new nimble playbook to work in March, cutting U.S. investment grade to neutral from overweight. We see less room for higher returns from tightening credit spreads but also see a decent amount of income with relatively limited risk compared with high yield. Still, we’re monitoring the impact of tighter credit and financial conditions as higher interest rates hit economic growth and reverberate through the banking sector. We’re also tactically overweight EM local currency debt on China’s powerful economic restart, peaking interest rate hikes and a broadly weaker U.S. dollar.

Bonds over stocks

Tactically, we prefer income from inflation-linked bonds over the dividend income provided by developed market (DM) equities. Equities can offer a sort of inflation protection if companies can pass on higher prices. But that depends on stocks reflecting the likely outlook for interest rates and growth – and we don’t think DM stocks are pricing the damage from higher rates that we see ahead. That’s a risk to dividends in the next 12 months – and the dividend yield of the S&P 500 is less than half of the 3.43% yield on the U.S. 10-year Treasury.

Bottom line: We see rates staying higher for longer in the new regime. That’s why we favour bonds for income. We like very short-term, high-quality government paper, EM local currency debt and high-quality credit.

Market backdrop

U.S. stocks rallied from a four-week low last week after tech earnings beat expectations, helping offset renewed regional bank woes. The U.S. two-year Treasury yield fell back near 4.0% even as the market eyes a Fed rate hike this week. U.S. PCE data showed consumer spending losing momentum over the course of the first quarter. Strong U.S. wage growth pointed to inflation settling well above 2% policy targets – why we believe hopes for rate cuts this year are misplaced.

This week’s focus will be on the Fed and ECB policy rate decisions. We think they’ll hike interest rates again – and we don’t see major central banks coming to the rescue with rate cuts this year as inflation remains sticky. We’re also watching U.S. jobs data where we expect to see ongoing labor market tightness. That is keeping wage growth and core inflation elevated.

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