An Update on Fixed Income Market Outlook and Positioning within our Strategic Model Portfolios
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Looking only at year-to-date returns across the U.S. fixed income market, particularly when compared to last year’s historical rout, you might conclude that 2023 is off to an uneventful start.
Fixed Income Sector Returns: 2023 YTD and 2022 Calendar Year
But fixed income markets have been anything but dull this year.
Throughout January, it seemed obvious to most market participants that the U.S. was entering a highly anticipated recession and inflation would cool accordingly. The yield on 10-Year U.S. Treasuries fell approximately 50 basis points in the first several weeks of the year before a string of hot economic and inflation data releases completely shifted the market narrative and pushed yields back up to 4%.
10-Yr U.S. Treasury Yield, Citi Economic Surprise Index: October 2022–Present
Where do we go from here?
While we did make modest adjustments to fixed income allocations throughout 2022, the strategic outlook of the WisdomTree Model Portfolio Investment Committee (MPIC) has remained intact in 2023.
WisdomTree Model Portfolio Investment Committee—Fixed Income Market Outlook
At WisdomTree, we are focused on several key themes across fixed income markets that shape our outlook and drive the positioning within our Model Portfolios:
1. Equity risk premium is near long-term average
In the years following the global financial crisis, interest rates near 0% meant investors received a healthy risk premium (earnings yield minus risk-free yield) for moving out of bonds into stocks. As higher interest rates have increased this risk-free yield, this expected premium on equity investments has clearly been reduced.
However, we do not agree with the view that today’s equity risk premium is dangerously low.
Importantly, since corporate earnings and dividends have historically kept up with inflation, long-term inflation-indexed (TIPS) yields are the most relevant comparator for calculating the equity risk premium. Using this approach, today’s equity risk premium has come down, but only to a level that is in line with long-term historical averages.
2. There’s income back in fixed income
While today’s equity risk premium certainly looks reasonable, it is undeniable that fixed income is back. With yields at levels a whole generation of investors have never seen, it is worth revisiting the role of bonds within a portfolio. Beyond the potential for diversification and downside protection, fixed income can once again deliver meaningful returns and income.
This is true even in shorter-term maturities with little to no duration or credit risk. For example, U.S. Treasury floating rate notes have a one-week duration and are now one of the highest-yielding Treasury instruments available.
The WisdomTree Floating Rate Treasury Fund (USFR) provides our Model Portfolios with access to this market and can continue to play a valuable role in today’s market environment.
3. Selectivity is key within corporate credit
While we are constructive on both investment-grade and high-yield corporate bonds, recession concerns clearly remain paramount for credit investors. To help mitigate the risk of downgrades and defaults weighing on potential returns, we utilize strategies such as the WisdomTree U.S. High Yield Corporate Bond Fund (WFHY), which focus on fundamentally sound corporate issues.
By incorporating a cash flow-based quality screen and tilting toward issues with attractive fundamental and income characteristics, WFHY has been able to avoid a large majority of the defaults experienced by the broader high-yield market.
4. Interest rate volatility remains elevated
As 2023 has proven in just a couple months, the future is still very much uncertain for the U.S. economy, inflation and Fed policy.
As investors continue reacting to incoming economic data, we expect ongoing volatility in both short-term and longer-term interest rates.
We maintained a short/under-weight duration position throughout 2022 and into the current year. Although it is still our “base case” scenario that interest rates remain higher for longer, a recession-induced cooling of price pressures remains a reasonable scenario.
Given this outlook and the inherent difficulty of predicting shorter-term movements in interest rates (see chart below), we modestly lengthened duration, reducing the size of this under-weight position, as part of our quarterly rebalance last September.
10-Yr U.S. Treasury Yield: Historical vs. Median Professional Forecast
WisdomTree Model Portfolio Investment Committee—Fixed Income Positioning
Based on the MPIC’s fixed income outlook, our positioning across strategic fixed income Model Portfolios is the following:
As we recently highlighted, positioning within our strategic fixed income strategy delivered positive relative performance in 2022.
While we have kept most of these key views intact into 2023, we are certainly not complacent. Our MPIC remains focused on both mitigating potential risks and capitalizing on attractive opportunities across today’s evolving fixed income market.
Financial advisors can learn more about the WisdomTree lineup of fixed income and multi-asset Model Portfolios by visiting our Model Adoption Center.
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