On Fixed Income
Long‑Dated Credit Can Boost Returns in a Tightening Environment
Shorter‑dated bonds are typically hit harder by rising inflation and low growth.
Kenneth Orchard Portfolio Manager
Onur Uncu Quantitative Analyst

Russia’s invasion of Ukraine has injected a heavy dose of uncertainty into the global economic outlook, but this month the U.S. Federal Reserve stuck to its plan to raise interest rates for the first time since 2018. Given the likely inflationary impact of the war, the Fed looks set to continue on its tightening path for the remainder of the year. For investors, then, the challenge of how to position their portfolios for a rising rate environment remains a pressing one.

The Fed’s determination to tighten financial conditions is hardly surprising. Stubborn inflationary trends caused by post‑pandemic easy monetary policy, supply chain disruptions, and rising energy prices have been a source of anxiety in markets for some time. Looming inflation puts pressure on central banks to tighten policy, which causes trouble for credit investors in two ways: first, rising bond yields have typically hit corporate bonds hard because of the duration1 embedded within them; and second, corporate bond spreads2 tend to be adversely affected by tighter financial conditions. In this article, we’ll focus on the latter.

"Higher policy rates generally make corporate borrowing more expensive..."
— Kenneth Orchard, Portfolio Manager

Higher policy rates generally make corporate borrowing more expensive as investors demand a premium over the policy rate when they lend to corporates. Rising borrowing costs eat into corporate profits, which is negative for corporate bond spreads.

Not all corporate bonds are equal, though. Monetary policy tends to normalize in the long term as growth slows and/or inflation subsides. Aware of this, the markets tend to price in the fact that shorter‑term bonds will be heavily exposed to short‑term risks while longer‑dated bonds will likely benefit from a normalization of conditions. This is evidenced by the fact that, historically, the Sharpe ratios (a measure of risk‑adjusted returns) of longer‑dated U.S. investment‑grade (IG) corporate bonds have been higher than shorter‑dated IG bonds when yields rose (Figure 1). This suggests that credit investors may be able to boost performance in the period ahead by potentially allocating more to longer‑dated credit.

"...unless inflation falls back, the Fed is likely to continue tightening..."
— Onur Uncu, Quantitative Analyst
Longer‑Dated U.S. IG Credit Has Outperformed During Periods of Rising Yields

(Fig. 1) Markets have typically priced in the normalization of policy in the long term

Markets have typically priced in the normalization of policy in the long term.

As of February 28, 2022.

Past performance is not a reliable indicator of future performance.

Based on monthly credit excess returns data between January 2000 and February 2022.We took monthly excess credit returns for each of the four tenors (maturity ranges) above. For eachmonth, we also calculated the change in the U.S. 10‑year treasury rate. We then took the subset of themonths where the U.S. 10‑year rate had gone up. In that subset, we calculated the annualized excessreturns and volatility for each tenor. The Sharpe ratio is calculated as the ratio of average annualizedexcess returns divided by average annualized excess return volatility.

Sources: Bloomberg Indices, Bloomberg Finance L.P.

It’s worth noting that the current tightening conditions differ from previous ones in a way that spells more risk for corporate bond spreads. Over the past 40 years, the Fed’s main goal with tightening has been to slow growth and prevent economic overheating; this time, it is trying to control inflation. This means that unless inflation falls back, the Fed is likely to continue tightening, even if growth is weaker than during previous tightening periods, which would hit shorter‑term credit harder than longer‑dated credit. An extended war in Ukraine could exacerbate this still further given that wars are invariably inflationary.

Positioning at the long end of the credit curve should have the additional benefit of being cash‑efficient. Long‑dated bonds tend to have higher “duration times spread” (a measure of the credit volatility of a corporate bond) per dollar invested. This means that a target risk level may be achieved with a smaller cash outlay. Allocating to longer‑dated corporate bonds, therefore, potentially allows investors to unlock cash that may then be used in other ways to generate yields, such as purchasing Treasury inflation protected securities (TIPS).

1 Duration measures a bond’s sensitivity to changes in interest rates.

2 Credit spreads measure the additional yield that investors demand for holding a bond with credit risk over a similar‑maturity, high‑quality government security.

 

Important Information

This material is provided for informational purposes only and is not intended to be investment advice or a recommendation to take any particular investment action.

The views contained herein are those of the authors as of March 2022 and are subject to change without notice; these views may differ from those of other T. Rowe Price associates.

This information is not intended to reflect a current or past recommendation concerning investments, investment strategies, or account types, advice of any kind, or a solicitation of an offer to buy or sell any securities or investment services. The opinions and commentary provided do not take into account the investment objectives or financial situation of any particular investor or class of investor. Please consider your own circumstances before making an investment decision.

Information contained herein is based upon sources we consider to be reliable; we do not, however, guarantee its accuracy.

Past performance is not a reliable indicator of future performance. All investments are subject to market risk, including the possible loss of principal. Fixed‑income securities are subject to credit risk, liquidity risk, call risk, and interest‑rate risk. Long‑dated bonds are subject to higher interest‑rate risk than short‑dated bonds. As interest rates rise, bond prices generally fall. In periods of no or low inflation, other types of bonds, such as US Treasury Bonds, may perform better than Treasury Inflation Protected Securities. All charts and tables are shown for illustrative purposes only.

T. Rowe Price Investment Services, Inc.

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