In today's investment landscape, fixed income options remain a crucial component of a balanced portfolio. These investments, often called bonds, offer investors a steady stream of income payments and a return on their principal investment at maturity.
In a recent investment research note, BCA Research considered the relative merits of four different fixed income investments in the current economic environment: 2-year Treasuries, 10-year Treasuries, Baa-rated corporate bonds and MBS ( agency mortgage-backed securities) with current coupon. ).
2-Year Treasury Bond Predictions
The investment firm said they estimate returns for both the two years and three different economic scenarios: a recession scenario, a soft landing scenario and a status quo scenario.
For the recession scenario, the company based its assumptions on what happened in the two most recent pre-COVID recessions (2001 and 2008).
It assessed how bond yields moved over the 12-month periods spanning from six months before the Fed's first rate cut to six months afterward. As a result, we assume a 287 bp drop in the 2-year Treasury yield and a 134 bp drop in the 10-year bond.
The soft landing scenario assumes that inflation gradually trends toward the Federal Reserve's target, but that the labor market remains firm and a recession is avoided.
BCA says this causes the Federal Reserve to cut rates at a pace of 25 basis points per quarter starting in September. “Furthermore, we assume that the market anticipates further modest policy easing at the end of our 12-month investment horizon, so our 12-month federal funds discount increases from its current -123 bps, but remains below zero at -50 bp,” says BCA.
“This gives us a target of 3.95% for the 2-year yield, 77 basis points below current levels. We also assume a modest inclination of the 2/10 curve, although we keep it inverted at -10 bp,” they add. “This gives us a 10-year yield target of 3.85%, 37 basis points below current levels.”
Finally, they state that the status quo scenario is designed to be a basis for the Federal Reserve to keep the policy rate unchanged while the market still anticipates that the next step will be a cut.
“An assumption of no change in the fed funds rate and a 12-month discount rising to -50 bps gives us a 4.94% target for the 2-year Treasury yield, 22 bps above current levels,” writes BCA. “Furthermore, we assume there will be no change to the 2/10 slope in this scenario, so the 10-year yield also increases by 22 basis points.”
Benefits of a 10-year Treasury bond
According to BCA Research analysts, the 10-year Treasury bond is purely a matter of duration.
“It compensates investors for assuming interest rate risk, but has no exposure to credit or convexity risk,” they explain.
Outlook for BAA-rated corporate bonds
According to BCA, the Baa-rated corporate bond carries a considerable amount of both interest rate risk and credit risk.
“While in some sense this makes the corporate bond the more dangerous option, the bond also benefits from the fact that returns from taking on credit risk and returns from taking on interest rate risk tend to be negatively correlated,” says the company.
The investment firm sees the soft landing scenario as where corporate bonds shine, noting that the combination of falling Treasury yields and tightening corporate bond spreads is a boon for the sector.
In this scenario, they believe that Baa-rated corporate bonds outperform the 1-year risk-free rate by 3.90% in the soft landing scenario, compared to an outperformance of 1.85% and 1.10. % for 10 and 2 year Treasury bonds.
Current MBS Coupon Agency for Investors
“Discount agency MBS are those securities that are currently trading at less than $0.98 per dollar. These securities represent around 85% of the MBS index of the Bloomberg agency and have an average coupon of 2.77%,” explains BCA. “Current coupon agency MBS represent a much smaller proportion of the index. They trade close to par and have an average coupon of 5.29%.”
Additionally, current coupon MBS have a shorter duration than discount MBS and offer a significant yield advantage.
The firm says the relative merits of the Agency's current MBS coupon become evident when the risk is considered alongside the expected return.
“Agency MBS perform reasonably well in both recession and soft landing scenarios with minimal variation,” BCA states.
Which fixed income investment is best for recessions or soft landings?
According to BCA, the Agency's current MBS coupon offers the best investment value in the US fixed income markets.
“Investors should maintain overweight positions in the sector and underweight positions in corporate bonds,” they argue. BCA also continues to recommend keeping portfolio duration neutral until clearer signs of labor market deterioration emerge.
Explore the benefits of bonuses
Investing in bonds is a strategic way to ensure portfolio stability and reliable income. Bonds, whether government or corporate, offer lower volatility compared to stocks and are vital for risk management. At Investing.com, the Bonds section includes comprehensive data on interest rates, bond prices and yield curves, helping investors effectively navigate the fixed income market.
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