Optimal Fixed Income Asset Allocation Over Economic and Monetary Policy Regimes

Geopolitical tensions, raging inflation, and increasingly active central banks have rattled markets since the start of the year. The meltdown spreading across asset classes—fixed income (FI), equity, commodities—has left investors looking for pockets of the market that may provide shelter.  

In this context, here we focus explicitly on FI markets and examine historical market dynamics to uncover evidence for U.S. core fixed income assets economic-regime dependence. We use this evidence to draw conclusions about optimal fixed income asset allocation within core U.S. markets over economic and policy cycles.  

We rely on the information from forward-looking fixed income markets and the dynamic behavior of the term structure of government bond yields to infer what markets perceive to be the prevalent economic cycle and the stance of central bank monetary policy. Specifically, we examine the time evolution of the slope of the government bond yield curve, approximated by the 2s10s yield spread, as our monetary policy regime identification framework1. We obtain our government bond yield curve data from FactSet fitted sovereign curves. Our choice for 2s10s yield spread as a proxy for the slope of the government bond yield curve follows a standard practice in the literature. In our analysis we focus on changes in the slope of the government bond yield curve on a twelve-month rolling period. 

Four Distinct Bond Market Environments 

We infer four distinct regimes from the way the broad government bond market perceives the underlying economic and policy trends: 

• Bear Flattener: A market environment characterized by a broad fixed income market sell-off with outperforming long-end rates. This environment is associated with a market assessment of strong and above-potential real economic activity (i.e., expansion) and / or inflationary pressures, causing nominal fixed income to sell off, and a central bank that is either already tightening policy to cool the economy down or is expected to do so imminently causing short-end rates to underperform relative to long-end rates.  
• Bull Flattener: A market environment characterized by a broad fixed income market rally with long rates outperforming. This environment is associated with a market assessment of a reduction in the pace of economic activity (i.e., slowdown) and / or more muted inflationary pressures, causing nominal fixed income to rally, and a central bank that continues to maintain a restrictive policy stance but is near the end of its tightening cycle. A restrictive policy stance, albeit on hold, and prospects of a cooling economy cause long-end rates to outperform relative to short-end rates. 
• Bull Steepener: A market environment characterized by a broad fixed income market rally with short rates outperforming. This environment is associated with a market assessment of below-potential real economic activity (i.e., recession) and / or below-objective inflation and / or deflationary pressures, causing nominal fixed income to rally, and a central bank that is either already loosening policy to revive the economy or is expected to do so imminently causing short-end rates to outperform relative to long-end rates.  

• Bear Steepener: a market environment characterized by a broad fixed income market sell-off with short rates outperforming. This environment is associated with a market assessment of still below potential but accelerating real economic activity (i.e., recovery) and / or still subdued but expected to revive inflationary pressures, causing nominal fixed income to sell off, and a central bank that continues to maintain an accommodative stance but is near the end of its loosening cycle. An accommodative policy stance, albeit on hold, and prospects of a reviving economy cause short-end rates to outperform relative to long-end rates.  

We summarize our conceptual thoughts and priors on economic and monetary policy regimes in Table 1.  

Current Environment: Bear Flattener 

Currently, our fixed-income-based economic and policy regime framework identifies a bear flattener environment. This observation squares with a period in which U.S. inflationary pressures are at multi-year highs and the U.S. Federal Reserve has communicated willingness to combat inflation through interest rate and quantitative tightening policies.  

What is the optimal way for investors to allocate capital within the core U.S. fixed income market in a regime with market perceptions of an overheating real economy and strong inflationary pressures and a monetary authority expected to fight such fundamental dynamics with restrictive policy? We attempt to examine this question by studying the performance of key asset classes within U.S. fixed income space—real government bonds (TIPS), nominal government bonds, investment-grade corporate bonds, and high-yield corporate bonds—along two main dimensions: asset class exposure to general interest rate risk and asset class exposure to credit risk.  

We approximate the first dimension by defining buckets according to bond remaining years to maturity (i.e., 1 to 3 years, 3 to 5 years, 5 to 7 years, and 7 to 10 years). We approximate the latter dimension by a) considering both “riskless” (government) and risky (corporate) debt and b) by further partitioning the corporate universe into smaller subsegments according to credit rating (i.e., “upper” and ‘’lower”).  

We perform the analysis on a monthly basis for the period January 2008 to April 2022. To make the analysis useful for real-world investment purposes we base our results on forward-period asset class performance, i.e., we study the one-month-ahead performance of various fixed income asset categories after identifying the prevalent regime at the end of the respective current month.  

Market perceptions of entering a mid-cycle stage of the monetary policy stance exhibit a clear pattern in terms of core U.S. fixed income assets performance. Table 2 displays performance in both price return terms (left table) and total return terms (right table2), calculated using FactSet’s Portfolio Analysis application.  

Enhanced non-risk-adjusted performance is achieved by tilting towards shorter-duration segments of the market (i.e., dampening the negative impact of rising bond yields because of a tightening central bank) and towards lower credit risk. Short-duration real government bonds (TIPS) offer the most favorable (i.e., least underperforming) non-risk-adjusted performance in this underlying regime relative to other fixed income investment alternatives. This is true in both price return and total return terms.  

The outperformance of the real / inflation-protected government bond segment, especially relative to nominal government debt, is not surprising in a regime in which the monetary authority adopts a more restrictive stance in response to an overheating economy and / or increasing inflationary pressures that erode nominal returns. 

While absolute price and total return performance is a key metric for investors with performance mandates and no access to leverage, those investors with access to borrowed capital may target assets and strategies that deliver superior performance on a risk-adjusted basis. Table 3 displays the risk-adjusted versions of the absolute return performance results shown in Table 2.  

Results from Table 2 continue to hold qualitatively on a risk-adjusted basis, as well. Levered investors may find superior performance per unit of risk exposure in the shorter-duration segment of the government bond sector with real debt exhibiting comparatively more favorable results. 

One related question of interest concerns the role played by credit risk in determining asset relative performance in the monetary policy regime examined in this article. The results in Table 2 for the Corporate IG bond and Corporate HY bond assets reveal that, for any level of exposure to general interest rate risk, performance deteriorates as investors go down the credit quality spectrum.  

To understand the drivers behind this observation we obtain asset performance for the two corporate bond assets in question attributed to two specific sources of performance: returns due to exposure to level shifts in the underlying Treasury curve (“shift” returns) and returns due to the dynamic behavior of yields that corporate bonds generate in excess of Treasury yields (“spread” returns), 3calculated using FactSet’s Portfolio Analysis application. We show these results in Table 4.  

While there are numerical differences across different maturity-and-asset groups, the left side of Table 4 reveals that returns due to exposures to level shifts in the Treasury curve are not sufficient to explain the documented differences in aggregate price-based performance in Table 2 across the corporate fixed income space. In contrast, clear patterns are visible in terms of spread performance differentials in the right side of Table 4.  

Within each years / maturity bucket, a deterioration in credit quality leads to a deterioration in the asset performance attributed to bond spread dynamics (i.e., issuers with greater perceived credit risk experience greater widening of their bond spreads during regimes characterized by overheating macro fundamentals and a restrictive monetary policy stance). We attribute this to the effect of rising costs of capital in this regime that markets internalize when evaluating the credit standing of individual debt issuers and consequently the higher premium that investors require for getting exposed to entities with less sound corporate fundamentals.  

Equally noteworthy, for any given perceived level of credit quality we observe a consistent deterioration in spread-related performance as one moves towards the longer end of the maturity spectrum. In a regime in which the central bank is perceived as actively restrictive in its monetary policy and in raising the cost of capital, investors require an increasing compensation for bearing corporate credit risk for longer periods of time. 

Conclusion 

Using information contained in the shape of the term structure of interest rates is useful for both identifying the dynamic evolution of the monetary policy stance and for studying relevant market behavior. In this article we provide a historical perspective on the performance of various segments of the core U.S. fixed income market in a mid-to-late cycle regime identified by peak real activity and inflationary pressures and a central bank that proactively seeks to meet its mandate of stabilizing the economy by adopting a restrictive policy stance.  

What is the distinct behavior of core U.S. fixed income asset classes in other identified regimes of the economic and policy cycle? Can the knowledge about this be used in a fixed income asset allocation portfolio framework and what would be the performance implications relative to investing in the broad U.S. fixed income market? We defer these questions to future research. 

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