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What’s the Buzz – Fixed Income Valuations

What’s the Buzz – Fixed Income Valuations

December 04, 2023

In a recent research publication on asset correlation, we stated (and re-stated in a recent publication on equity valuations):

“Simply put, if we combine the fact correlations are higher during periods with positive equity returns, and we add to this that positive correlations are also supported by inflation, asset allocation (as always) is driven by the outlook for asset class returns and inflation (as inflation influences asset class returns).  If an investor believes that the economy will be inflationary, he or she can reasonably expect asset class returns to have similar returns – directionally.  In other words, positive (negative) equity returns and positive (negative) bond returns.  Historically speaking, an investor who believes that the outlook for equity returns is positive, and given that over time equities outperform bonds, the investor will overweight equities in order to capture higher returns.  This does not mean, however, an investor will shun bonds, as doing so will create a significant tilt higher in risk.”

“That said, an investor can also see an inflationary environment, or a period where inflation is higher than desired, and believe that stocks will NOT outperform bonds near-term.  In this case, the investor will tactically (near-term) reduce their allocation to equities and increase their allocation to bonds.”

As correlations are still positive (as the updated charts below show), an investor should review valuations for the various asset classes contained within (or being considered for) their portfolio.

From a rolling twelve-month perspective:

Source: BCIS/Bloomberg

From a rolling 30-day perspective:

Source: BCIS/Bloomberg

When we looked at equities, we concluded:

Ultimately, we believe equities are fairly valued to a little rich at this juncture and are hesitant to add risk in the asset class as we believe there are other asset classes that are more attractive from a risk/return standpoint.

This leads us to the fixed income asset class.  To review this asset class, we will be using the Bloomberg US Aggregate for market and sector data as it represents nearly 50 percent of the global market (as measured by the Bloomberg Global Aggregate) and is the primary market used with investors, including our clients and advisors.  The aggregate is comprised of the following sectors: Treasuries, fixed rate Mortgage-backed securities (“MBS”), credit (primarily debt of corporations), government debt (government agency debt), and non-MBS securitized debt.

 

Source: BCIS/Bloomberg

There are two measures that are often used when looking at fixed income – the absolute yield (yield-to-worst or “YTW”) and the relative yield.  The relative yield that is used is the option adjusted spread (“OAS”), or the difference in yield between a bond/index with credit risk or pre-payment risk and the duration matched risk-free rate, this is, essentially, the risk premium on the bond with credit risk.

In the charts below, these characteristics (OAS and YTW) of the bond market, when aggregated, are shown in a historical context, as well as the averages and standard deviation(s) from the average (standard deviation is a statistical value used to determine how spread out the data in a sample are, and how close individual data points are to the value of the sample, where 68 percent of all data lies within one standard deviation and 95 percent lie within two standard deviations).

Source: BCIS/Bloomberg

As the charts above show, on an OAS (risk premium) basis, the index is slightly below its historical average.  On an absolute yield (YTW) basis, however, it is above one standard deviation above the average, which is better.  Given the current YTW of 5.65 percent, may investors have been buying into the fixed income market at the highest yield in nearly 25 years.  In this respect, we find the fixed income market appealing.

Source: BCIS/Bloomberg

Of course, investors can also invest in the sub-sectors of the market and tailor the risk of their fixed income holdings to meet their risk profile.  In this regard, many investors, including us at BCIS, look at the credit and mortgage (MBS) sectors due to their yield advantage specific characteristics.

The Bloomberg US Corporate Bond Index measures the investment grade, fixed-rate, taxable corporate bond market. It includes USD denominated securities publicly issued by US and non-US industrial, utility, and financial issuers (as defined by Bloomberg).  In the charts below, the characteristics (OAS and YTW) of the credit market are shown in a historical context, as well as the averages and standard deviation(s) from the average.

Source: BCIS/Bloomberg

Again, we see that the OAS is hovering a little below the average, making the risk premium received somewhat neutral. On an absolute yield (YTW) basis, however, it is above one standard deviation above the average, which is better.  Given the current YTW of 6.35 percent, may investors have been buying into the fixed income market at the highest yield in since the global financial crisis.  In this respect, we find the credit market very appealing.

Source: BCIS/Bloomberg

The Bloomberg US Mortgage-Backed Securities (MBS) Index tracks fixed-rate agency mortgage-backed pass-through securities guaranteed by Ginnie Mae (GNMA), Fannie Mae (FNMA), and Freddie Mac (FHLMC) (as defined by Bloomberg).  In the charts below, the characteristics (OAS and YTW) of the MBS market are shown in a historical context, as well as the averages and standard deviation(s) from the average.

Source: BCIS/Bloomberg

Unlike the broader index and the credit index, the OAS on the mortgage-backed index is nearing one standard deviation above the average OAS, making the index compelling on a risk premium basis.  Similarly, on an absolute yield (YTW) basis, however, it is above one standard deviation above the average, which is better.  Given the current YTW of 5.93 percent, many investors have been buying into the mortgage-backed market at the highest yield in since the global financial crisis.  In this respect, we find the credit market very appealing as well.

Source: BCIS/Bloomberg

The bottom line on option adjusted spread and yield-to-worst:  We believe fixed income is very compelling at this juncture – more so than at any point in the last decade.  We recommend a fixed income overweight, with that overweight taken in the credit and mortgage-backed sectors.

Another way to look at valuation is the equity risk premium, which we also highlighted in our equity valuation research publication (and have updated here).  While there are different ways to calculate and express this, we will use a comparison between the earnings yield of the market and the “risk free” interest rate.  Using the Russell 1000 (large cap) earnings yield and the three-month and two-year Treasury rates results in the following:

Source: BCIS/Bloomberg

This is not isolated to large cap stocks.  The following chart shows the same data versus the Russell 3000 broad market index (approximately 98 percent of the investable U.S. market):

Source: BCIS/Bloomberg

The bottom line on the equity risk premium charts:  The drop in the earnings yield of the equity market(s) below the risk-free rate(s) implies moderate over-valuation of equities and the attractiveness of rates.  In other words, we find the general level of interest rates attractive at this juncture, supporting the recommended overweight in fixed income.

As we did in the equity valuations publication, we will also look at the Z Score within the fixed income markets. In order to facilitate an apples-to-apples comparison between these markets, we will look at the Option adjusted spread and the Z-score of the spread (essentially the number of standard deviations the current OAS is from the mean, or average OAS) over various time periods.  In the following chart, the values are highlighted from green to red, with the values highlighted in green as those most attractive from a Z-score basis.

Source: BCIS/Bloomberg

As the table above shows, mortgage-backed securities are the “cheapest” in a relative sense and are, therefore, very attractive.  While the US Aggregate and US Credit indices are not as appealing in the one-year time frame, and credit is “tighter” (lower risk premium) than it has been historically, we believe that the yield will provide the “carry” which will generate the majority of the returns over time (as shown in the chart below).

Source: Bloomberg

The bottom line on the Z-score data:  We believe that the broader US market, as represented by the Bloomberg US Aggregate index is attractive and the fixed income asset class should have an overweight position.  Mortgage-backed securities are our favorite sector in fixed income, and we believe that it should receive a large part of the fixed income overweight.

Ultimately, we believe fixed income is cheap broadly speaking and has a coupon and yield that investors have not seen in over a decade. As a result of this belief, we believe a modest overweight to fixed income is in order and may help investors generate better risk-adjusted returns. If you would like to discuss this further, please call your financial advisor and we will be happy to review this and the implications for your portfolio.



The views expressed in this publication are those of the author and do not necessarily reflect the views and opinions of Cetera Advisor LLC or Burrows Capital Advisors.

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