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Text on screen: PIMCO Quick Takes: With Bonds, Higher Rates Can Lead to Higher Returns
Text on screen: Sean Klein, Client Solutions and Analytics
Klein: Investors today are able to enjoy yields that they haven’t seen for almost a generation.
While many market participants expect inflation - a key driver of those higher yields – to moderate in 2023, the ultimate economic environment will obviously impact the level of interest rates and asset returns.
FULL PAGE GRAPHIC: TITLE – Sample yield curve scenarios over a multi-year horizon, Sub-heading: Core bond returns: realized vs. simulated
Description: The graphic displays two bar graphs arranged side-by-side, with a summary box below them. The first graph measures the 1-year return of core bond portfolios across five different scenarios. The first scenario is the historical realized return, while the second, third, fourth, and fifth scenarios are simulated scenarios. They simulate the traditional growth, goldilocks, recession, and stagflation scenarios, respectively. The 1-year graph shows core bond portfolios declining by 8.1% and 2.8% in the historical and traditional growth scenarios, respectively, and appreciating by 2.2%, 10.1%, and 3.2%, respectively, in the simulated goldilocks, recession, and stagflation scenarios. The second graph measures the 5-year return of core bond portfolios across the same five scenarios measured in the first graph. In the 5-year graph, all 5 scenarios are positive— the historical realized, traditional growth, goldilocks, recession, and stagflation all report appreciation in value. The four simulated scenarios report approximately 4-5% appreciation, while the historical realized scenario reports 0.7% appreciation. The summary box below the two charts states the following: “Core bond returns are positive in the long run under a wide range of macro scenarios,” and “Forward-looking returns for core bonds are stronger than recent historical returns.”
Now, it’s no secret that rate increases lower bond prices, but higher rates today may potentially lead to higher returns in the future. In core bonds for example, we estimate that after only five years, most of any initial rate shock washes out and it is instead the initial valuations that determine the final outcomes.
Today, those valuations are quite attractive. And attractive valuations in fixed income come with more confidence than they do for other asset classes.
For example, when we think about the fair value of equities, a common starting point is the cyclically adjusted earnings yield.
This is a calculation that looks at long term corporate earnings relative to the market’s total price.
FULL PAGE GRAPHIC: TITLE – Valuations vs. future performance in equities and fixed income, Sub-heading: Returns tend to be more predictable in credit than equities.
Description: The graphic displays two line charts arranged side-by-side, with a table below them. The first chart measures the expected returns of the S&P 500 against the S&P 500’s 5-year forward realized return, over the period spanning from 1987 to 2022. The second chart measures the expected returns of the Bloomberg US Corporate High Yield Bond Index against the Bloomberg US Corporate High Yield Bond Index’s 5-year forward realized return, also over the period spanning from 1987 to 2022. The S&P 500-focused chart shows significant variation between the expected and realized returns, while the Bloomberg US Corporate High Yield-focused chart displays a much stronger correlation between the expected and realized returns. The table below the two charts provides statistical verification for the increased correlation, noting that the S&P 500 returns, expected vs. realized, hold a 24% correlation, while the Bloomberg returns, expected vs. realized, hold a 61% correlation.
This is a standard measure of equity values and while we can see there is definitely some relationship there, it’s rather weak. While rates and earnings matter, so do those Keynesian animal spirits.
For bonds, though, we see a different picture. While there are more subtle, more powerful measures out there, we don’t have to do any special calculations to get a indication of value. Even for high yield bonds, if we just looked at historical yields, we would have known a lot more about their future performance than we ever would have with stocks.
While markets are inherently unpredictable, there is little doubt that rates today are more attractive than they have been in a very long time. Higher rates lower bond prices, sure, but they increase the appeal of fixed income for longer horizon investors because they signal higher future returns.
And that’s a signal that means a great deal more in fixed income than almost any other asset class.
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Disclosure
Past performance is not a guarantee or a reliable indicator of future results.
The analysis contained herein is based on hypothetical modeling. HYPOTHETICAL PERFORMANCE RESULTS HAVE MANY INHERENT LIMITATIONS, SOME OF WHICH ARE DESCRIBED BELOW. NO REPRESENTATION IS BEING MADE THAT ANY ACCOUNT WILL OR IS LIKELY TO ACHIEVE PROFITS OR LOSSES SIMILAR TO THOSE SHOWN. IN FACT, THERE ARE FREQUENTLY SHARP DIFFERENCES BETWEEN HYPOTHETICAL PERFORMANCE RESULTS AND THE ACTUAL RESULTS SUBSEQUENTLY ACHIEVED BY ANY PARTICULAR TRADING PROGRAM.
ONE OF THE LIMITATIONS OF HYPOTHETICAL PERFORMANCE RESULTS IS THAT THEY ARE GENERALLY PREPARED WITH THE BENEFIT OF HINDSIGHT. IN ADDITION, HYPOTHETICAL TRADING DOES NOT INVOLVE FINANCIAL RISK, AND NO HYPOTHETICAL TRADING RECORD CAN COMPLETELY ACCOUNT FOR THE IMPACT OF FINANCIAL RISK IN ACTUAL TRADING. FOR EXAMPLE, THE ABILITY TO WITHSTAND LOSSES OR TO ADHERE TO A PARTICULAR TRADING PROGRAM IN SPITE OF TRADING LOSSES ARE MATERIAL POINTS WHICH CAN ALSO ADVERSELY AFFECT ACTUAL TRADING RESULTS. THERE ARE NUMEROUS OTHER FACTORS RELATED TO THE MARKETS IN GENERAL OR TO THE IMPLEMENTATION OF ANY SPECIFIC TRADING PROGRAM WHICH CANNOT BE FULLY ACCOUNTED FOR IN THE PREPARATION OF HYPOTHETICAL PERFORMANCE RESULTS AND ALL OF WHICH CAN ADVERSELY AFFECT ACTUAL TRADING RESULTS.
Because of limitations of these modeling techniques, we make no representation that use of these models will actually reflect future results, or that any investment actually will achieve results similar to those shown. Hypothetical or simulated performance modeling techniques have inherent limitations. These techniques do not predict future actual performance and are limited by assumptions that future market events will behave similarly to historical time periods or theoretical models. Future events very often occur to causal relationships not anticipated by such models, and it should be expected that sharp differences will often occur between the results of these models and actual investment results.
Stress testing involves asset or portfolio modeling techniques that attempt to simulate possible performance outcomes using historical data and/or hypothetical performance modeling events. These methodologies can include among other things, use of historical data modeling, various factor or market change assumptions, different valuation models and subjective judgments.
Return assumptions are for illustrative purposes only and are not a prediction or a projection of return. Return assumption is an estimate of what investments may earn on average over a 5 year period. Actual returns may be higher or lower than those shown and may vary substantially over shorter time periods. Return assumptions are subject to change without notice.
Forecasts, estimates and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. There is no guarantee that results will be achieved.
Figures are provided for illustrative purposes and are not indicative of the past or future performance of any PIMCO product. It is not possible to invest directly into an unmanaged index.
All investments contain risk and may lose value. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and low interest rate environments increase this risk. Reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Equities may decline in value due to both real and perceived general market, economic and industry conditions. Investors should consult their investment professional prior to making an investment decision.
R-Squared is a statistical measure that represents the percentage of a portfolio's movements that can be explained by movements in a benchmark index.
This material contains the opinions of the manager and such opinions are subject to change without notice. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.
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