As a follow up to the piece we published in July that focused on decelerating economic growth and equity returns, we thought it made sense to look at how some fixed income sectors fared during the same periods. We researched this concept to better understand the historical relationship between an economic slowdown, credit spreads, and total returns.
In this analysis, we looked at the three most recent periods over the last 25 years of peak to trough real GDP movement. We quantified the number of quarters of deceleration and the time periods in which the slowdown occurred. This data is shown in Exhibit 1.
Periods of slowing economic growth
Exhibit 1: Peak to trough real GDP
Source: Federal Reserve Bank of St. Louis
We observe three periods of significant GDP deceleration over the last 25 years. Note the duration of these economic slowdowns was 21 quarters (or 5¼ years) during the two most recent periods. For the first period we looked at for fixed income, the duration was only six quarters.
Source: Federal Reserve Bank of St. Louis, NBER. Shaded areas represent recession.
Fixed income spread widening
We then quantified spread levels for multiple fixed income sectors inside the Bloomberg U.S. Aggregate Bond Index as well as a multiple sectors outside of this widely-used bond benchmark. This data is shown in Exhibits 2 and 3.
Exhibit 2: Spread changes in bps (red indicates widening)
Exhibit 3: Spread levels during recent periods of slowing growth
Excess Yield over Treasuries (bps) – Spreads at GDP Peak vs. GDP Trough (6/30/00-12/31/01)
Excess Yield over Treasuries (bps) – Spreads at GDP Peak vs. GDP Trough (3/31/04-6/30/09)
Excess Yield over Treasuries (bps) – Spreads at GDP Peak vs. GDP Trough (3/31/15-6/30/20)
Fixed income performance
We then looked at total returns for the sectors inside the Bloomberg U.S. Aggregate Bond Index and the sectors outside of the Bloomberg U.S. Aggregate Bond Index. This data is shown in Exhibit 4.
Exhibit 4: Total returns (annualized)
Source: Bloomberg, JP Morgan, Putnam
The fixed income data set is limited to 25 years, however we believe the following observations still have merit. In every instance but one, spreads widened across fixed income risk assets. However, and also with one exception, performance was positive during the periods of GDP deceleration.
During periods of economic deceleration, equities are pressured, but fixed income risk assets also feel stress. These challenges are evident when looking at the changes in spreads – the additional yield investors demand in a fixed income asset relative to a U.S. Treasury note with a similar duration. When growth slowed, spreads generally widened for both sectors inside the U.S. Aggregate Bond Index, such as investment grade commercial mortgage backed securities and investment grade corporate debt, as well as for sectors outside the U.S. Aggregate Bond Index, such as high yield corporate bonds and U.S. dollar denominated emerging market debt. However, with only one modest exception, over the last 25 years in periods when GDP slowed, fixed income sectors delivered positive total returns.
Finally, we believe the primary reasons to own fixed income assets remain valid. Namely, to distribute income to investors, to serve as a diversifier of equities, and potentially dampen portfolio volatility.
The views and opinions expressed are those of the authors, are subject to change with market conditions and are not meant as investment advice.
Gross domestic product (GDP) is the total monetary or market value of all the finished goods and services produced within a country’s borders in a specific time period; changes in GDP are an indicator of a nation’s overall economic health.
The Bloomberg U.S. Aggregate Bond Index is an unmanaged index of U.S. investment-grade fixed income securities.
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