March Madness: Top Picks for Fixed Income Investing

Fixed income investing in 2023 is about balancing risk and opportunity. Making smart selections, not being afraid to go non-consensus, and trying to avoid getting upset. Which bond category has what it takes to cut down the nets? In the spirit of March Madness, here is my bond bracketology and overall picks for fixed income standouts.

Round 1
(1) Short-Term Bond vs. (16) EM Local Currency
With short-term bonds, I get a more than adequate yield, significantly lower volatility than Emerging Market debt, and of course no currency exposure. Short-Term Bond is my pick.

(8) Global Bond USD Hedged vs. (9) Inflation-Protected Bond
TIPS (Treasury Inflation-Protected Securities) actually give you a higher nominal yield than many global bond strategies, while protecting against a stagflation. Hedged global bonds likely get you redundant sovereign and corporate bond exposures already found elsewhere in your portfolio. Inflation-Protected Bond.

(5) High Yield Bond vs. (12) Bank Loan
Bank loans are outyielding many high yield corporate strategies by almost 1%; they sit higher in the capital structure and have a more distant maturity wall. This could be a classic 12-5 upset. Bank Loan.

(4) Ultrashort Bond vs. (13) Corporate Bond
Ultrashort may protect against price volatility, but at the cost of higher reinvestment risk. If you buy a 6-month Treasury, you need to buy a new one six months from now. There is no guarantee you will have the same yield environment then. Now consider the tail risk from a low probability, but highly disruptive potential US default later in the year. It probably makes sense to avoid going too short on the curve. I’m taking Corporate Bond in another upset.

(6) Muni National Intermediate vs. (11) Nontraditional Bond
I like the flexibility and lower duration profile of nontraditional bond to complement other exposures. But ultimately, I’ll take the higher quality profile you get with municipal bonds, plus the tax-efficient yield and the lower empirical duration in stretches of Treasury volatility. Munis in a buzzer beater.

(3) Intermediate Core vs. (14) Emerging Market Bond
I’d like to stay a bit defensive, so I’ll take the asset class with close to 100% investment grade exposure over the asset class with 50% investment grade exposure. Intermediate Core.

(7) Multi-Sector vs. (10) Intermediate Government
The massively inverted yield curve forces fixed income investors to be creative to access duration exposure. I’d rather lean on active management in the middle part of the curve. Give me the ability to cast a slightly wider net here. Multi-Sector.

(2) Intermediate Core Plus vs. (15) Global Bond
Global bonds give you lower yield and higher equity beta amidst rumors of Japan ending yield curve control. No thank you. Core Plus in a blowout.

Round 2
(1) Short-Term Bond vs. (9) Inflation-Protected Bond
If rates stay range-bound, short-term bonds should provide higher returns on the strength of the higher yield. If rates rise due to higher real rates, short-term bonds win as well. Inflation reacceleration seems less likely. I’ll pencil in Short-Term Bond here.

(12) Bank Loan vs. (13) Corporate Bond
In a matchup of double-digit seeds, I’ll take the asset category providing nearly double-digit yields. Bank Loan.

(3) Intermediate Core vs. (6) Muni National Intermediate
While tax-equivalent municipal bond yields remain decent, Muni-to-Treasury ratios have been grinding lower since October. Intermediate Core advances.

(2) Intermediate Core Plus vs. (7) Multi-Sector
In a matchup of two asset categories with some flexibility for active management, I’ll take the higher quality, more defensive pick here with something that will better serve as a portfolio anchor. Core Plus.

Semi-Finals
(1) Short-Term Bond vs. (13) Bank Loan
I still like bank loans as a carry trade, but in a battle of two of the categories that held up best in 2022, I’m going with the “sleep better at night” pick and it’s Short-Term Bond.

(2) Intermediate Core Plus vs. (3) Intermediate Core
Recession risks remain but the potential for a soft landing may be underappreciated. If spreads act up over the next few months, I’ll take something that can put some dry powder to work. Core Plus.

Finals
(1) Short-Term Bond vs. (2) Intermediate Core Plus
On the surface it might seem crazy to move out in duration and accept a lower yield with presumably higher volatility. The Treasury yield curve is more inverted now than it has been in 40 years. Shouldn’t that reverse at some point? Allocating a portion of your portfolio to short-term bonds and happily accepting what appears to be a very attractive risk-adjusted return is certainly sensible. But I wouldn’t put the majority of my allocation there. The yield curve is inverted because most investors agree that there will be interest rate cuts in the future. What’s not known is the timing, pace, and size of those cuts. The duration effect of lower rates can easily overwhelm any advantage in yield carry. For example, if the 2-year falls 100 basis points and the 10-year falls just 25 basis points, you still get a better return at the 10-year. The positive price action from falling rates wipes away any carry advantage.

To me this is one highly plausible, potentially tame market outcome that would lead to yield curve normalization and still favor duration. Now consider the downside protection and equity risk offset from duration in a risk-off environment. It didn’t work so well a year ago with starting yields in the 1% range, but it should be a lot more doable with the cushion of a starting yield of 4%–5%. Maybe there will be a more obvious entry point later in the year or next year where rate volatility subsides, yields are still high, and the curve appears more normal. But maybe there won’t. Falling rates have a tendency to catch people by surprise. The Pick – Intermediate Core Plus.