In today's investment landscape, fixed income options remain a crucial component of a balanced portfolio. These investments, often referred to as 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 current coupon Agency MBS (Mortgage-Backed Securities).
2-Year Treasury Bond Predictions
The investment firm said they estimate returns for both the 2-year and 10-year Treasury notes in three different economic scenarios: a recession scenario, a soft landing scenario, and a status quo scenario.
For the recession scenario, the firm based its assumptions on what happened in the two most recent pre-COVID recessions (2001 and 2008).
It assessed how bond yields moved during the 12-month periods spanning from six months before the first Fed rate cut to six months after. As a result, it assumes a 287 bps drop in the 2-year Treasury yield and a 134 bps drop in the 10-year.
The soft landing scenario assumes inflation gradually trends back toward the Fed’s target but that the labor market holds firm and a recession is avoided.
BCA says this causes the Fed to cut rates at a pace of 25 bps per quarter starting in September. “Additionally, we assume that the market anticipates further modest policy easing at the end of our 12-month investment horizon, so our 12-month Fed Funds discounter rises from its current -123 bps but remains below zero at -50 bps,” says BCA.
“This gives us a target of 3.95% for the 2-year yield, 77 bps below current levels. We additionally assume a modest steepening of the 2/10 curve, though we keep it inverted at -10 Bps,” they add. “This gives us a 10-year yield target of 3.85%, 37 bps below current levels.”
Finally, they state the status quo scenario is designed to be a baseline where the Fed keeps the policy rate unchanged while the market still anticipates that the next move will be a cut.
“An assumption of no change in the fed funds rate and a 12-month Discounter rising to -50 bps gives us a target of 4.94% for the 2-year Treasury yield, 22 bps above current levels,” writes BCA. “Additionally, we assume no change in 2/10 slope in this scenario, so the 10-year yield also rises by 22 bps.”
Benefits Of a 10-Year Treasury Bond
According to BCA Research analysts, the 10-year Treasury note is the pure duration play.
“It compensates investors for taking interest rate risk but has no exposure to credit or convexity risk,” they explain.
BAA-Rated Corporate Bond Outlook
According to BCA, the Baa-rated corporate bond carries a fair amount of both interest rate risk and credit risk.
“While in one sense this makes the corporate bond the most dangerous choice, the bond also benefits from the fact that returns for taking credit risk and returns for taking interest rate risk tend to be negatively correlated,” says the firm.
The investment firm feels that the soft landing scenario is where corporate bonds shine, noting the combination of falling Treasury yields and tightening corporate bond spreads as being a huge boon for the sector.
In this scenario, they believe Baa-rated corporate bonds outperform the 1-year risk-free rate by 3.90% in the soft landing scenario, compared to 1.85% and 1.10% outperformance for the 10-year and 2-year Treasury notes.
Current Coupon Agency MBS For Investors
“Discount Agency MBS are those securities currently trading at less than $0.98 on the dollar. These securities make up about 85% of the Bloomberg Agency MBS index and have an average coupon of 2.77%,” explains BCA. “Current coupon Agency MBS are a much smaller proportion of the index. They trade close to par and have an average coupon of 5.29%.”
In addition, current coupon MBS have a lower duration than discount MBS and offer a significant yield advantage.
The firm says the relative merits of the current coupon Agency MBS become apparent when risk is considered alongside expected return.
“Agency MBS perform reasonably well in both the recession and soft landing scenarios with minimal variance,” states BCA.
Which Fixed Income Investment Is Best For Recessions or Soft landings?
According to BCA, the current coupon Agency MBS offers the best investment value in US fixed-income markets.
“Investors should hold overweight positions in the sector and underweight positions in corporate bonds,” they argue. BCA also continues to recommend keeping portfolio duration at neutral until clearer signs of labor market deterioration emerge.
Explore the Benefits of Bonds
Investing in bonds is a strategic way to ensure portfolio stability and reliable income. Bonds, whether from governments or corporations, offer lower volatility compared to stocks and are vital for risk management. On Investing.com, the Bonds section features comprehensive data on interest rates, bond prices, and yield curves, helping investors navigate the fixed income market effectively.