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Economic and Market Commentary

Why Yield Matters

Attractive starting yields underpin our constructive outlook for fixed income.

After nearly three years of interest rate volatility that tried many investors’ nerves, the outlook for bonds appears the healthiest in years thanks to two key factors: Starting yields are near their highest levels in more than a decade, and markets are on watch for central banks globally to start easing policy after the recent hiking cycle.

Of course, investors are understandably cautious. The historic rate increases in 2022 led to negative returns in most fixed income sectors. In 2023 and 2024, many investors began moving cash off the sidelines as yields reset at healthier levels, only to face renewed volatility.

However, history suggests that today’s starting conditions could add up in bond investors’ favor.

This content is provided for educational purposes only and should not be viewed as investment advice or as an offering of any product or strategy. Consult your financial professional for more information.

A compelling entry point

The compelling nature of today’s fixed income entry point is demonstrated by Figure 1, which outlines potential returns across various fixed income sectors based on current yields and illustrative interest rate movements. This analysis reveals that current starting yields may help anchor return potential for bonds at attractive levels, while also providing a cushion against any further increases in interest rates.

For example, in the multisector bond category, if 2024 follows a similar path as 2023 and rates end where they start, return expectations are a healthy 6%. If rates were to rise, they would need to hit nearly 7% – an increase of over 200 basis points – to turn estimated multisector returns negative, assuming credit spreads remain constant.

Categories with more duration, or interest rate sensitivity, such as core bonds, may also offer a compelling trade-off. Unlike 2022 when starting yields were much lower, returns today are likely to remain positive even with modest further increases in rates. However, if rates fall even 1 percentage point, returns could climb into double digits.

The one category that shouldn’t benefit from falling rates? Cash investments, as a decline in short rates can quickly result in a decline in returns. That’s not to mention the potential opportunity cost missed by not participating in the drop in interest rates and the likely rally one would experience across most fixed income sectors.

Figure 1: High starting yields hold potential for meaningful gains

Figure 1 presents 12-month total return estimates for different segments of the bond market under varying interest rate scenarios, ranging from a 3% decrease to a 3% increase. It illustrates that assets with higher interest rate risk exhibit a broader spectrum of outcomes, with potential for both positive returns if yields fall and negative returns if yields rise. Diversified investments, such as multisector fixed income, demonstrate greater resilience across a variety of scenarios. For instance, multisector bonds are expected to yield a 6% return in 2024 if interest rates remain stable, capable of withstanding up to a 200 basis point increase without falling into negative return territory. This analysis is based on data from Bloomberg and PIMCO as of March 31, 2024.

Source: Bloomberg and PIMCO as of 31 March 2024. For illustrative purposes only. Figure is not indicative of the past or future results of any PIMCO product or strategy. There is no assurance that the stated results will be achieved.

Global Agg: Bloomberg Global Aggregate Index (USD-H) , Global IG Credit: Bloomberg Global Aggregate Credit Index (USD-H), Multisector: Morningstar Multisector Bond Category

1 Treasury tenors correspond to a hypothetical treasury bond with the stated maturity which matches the yield on the current treasury curve. In the analysis contained herein, PIMCO has outlined hypothetical event scenarios which, in theory, would impact the yield curves as illustrated in this analysis. No representation is being made that these scenarios are likely to occur or that any portfolio is likely to achieve profits, losses, or results similar to those shown. The scenario does not represent all possible outcomes and the analysis does not take into account all aspects of risk. Total returns are estimated by re-pricing key rate duration replicating portfolios of par-coupon bonds. All scenarios hold OAS constant.

Starting conditions matter

Last year was a clear reminder of the pivotal role that high starting yields play in mitigating downside risks and driving positive returns in fixed income. In the U.S., for example, despite the significant intra-year move in rates, with the 10-year U.S. Treasury yield briefly touching 5% in October, many yields further out the U.S. Treasury curve ended the year roughly where they began. In fact, the 10-year U.S. Treasury yield started and ended 2023 at exactly the same level of 3.88%.

That round trip in yields enabled bonds to end the year on a high note, with returns in the mid to high single digits, as starting yields drove attractive returns. In fact, across most major fixed income sectors, a majority of 2023 returns were driven by yield as opposed to price movements. The rally in interest rates in November and December largely reversed price losses from rising rates earlier in the year.

Additionally, though rates rose through October, most fixed income sectors remained positive or only dipped modestly into negative territory as income from higher yields helped offset price losses. That was not the case in 2022, when much lower starting yields and sharper movements in interest rates and spreads drove most fixed income sectors into negative territory. Importantly, looking forward, starting yields in 2024 are much closer to the high levels of 2023 than the lows of 2022. For example, while the yield on the Bloomberg US Aggregate Bond Index stood at 1.70% to start 2022, those levels were 4.65% and 4.52% to start 2023 and 2024, respectively.

Based on history, bonds may still have considerable upside

History suggests we may be in the early days of a bond market rally. As Figure 2 shows, using the U.S. as an example, over the last seven Federal Reserve (the Fed) rate-hiking cycles since 1978, bond market rallies have tended to last more than a year or two after the final hike.

Additionally, as the Fed begins to ease, front-end yields have tended to fall significantly, which hinders cash returns. Meanwhile, even modest declines in interest rates at longer maturities have tended to lead to notable outperformance for fixed income portfolios due to the price appreciation that falling rates provide.

Figure 2: Historically, the end of Fed rate-hiking cycles leads to sharp declines in yields and attractive bond returns

Figure 2 provides a historical analysis of the periods following each of the last seven U.S. Federal Reserve rate-hiking cycles since the early 1980s. It compares yield movements and the performance of the Bloomberg US Aggregate Index and 3-month T-bills in the 24 months after the fed funds rate peak. Historically, bond market rallies have often continued for more than a year or two post the Federal Reserve's final rate hike. When the Fed starts to lower rates, short-term yields typically decrease, potentially impacting returns negatively. However, slight reductions in long-term interest rates can significantly enhance fixed income portfolio performance through price appreciation.

Source: Barclays and PIMCO as of 31 December 2023

Past performance is not a guarantee or a reliable indicator of future results.

Bloomberg (BBG) US Aggregate Index. Yield-to-Worst (YTW) is the estimated lowest potential yield that can be received on a bond without the issuer actually defaulting. Hiking cycles are defined as periods when the Federal Reserve embarks on a sustained path of increasing the target fed funds rate and/or target range. We define the end of a hiking cycle as the month where the Fed reaches its peak policy rate for that cycle (i.e., it either pauses rate hikes or cuts). Hiking cycles include (start to peak). 1980 (Jul '80 to May '81), 1983 (Feb'83 to Aug '84), May 1988 (Feb '88 to Mar '89), 1994 (Jan '94 to Feb '95), 1999 (May '99 to May '00), 2004 (May '04 to Jun '06) and 2015 (Nov '15 to Dec '18).

Looking ahead

While short rates are higher and cash-equivalent investments may remain attractive in the near term, we believe fixed income is the more compelling long-term investment. Yields across most fixed income sectors are at attractive levels rarely seen in the last 20 years. Additionally, compared with last year, the prospect of falling rates could provide an additional tailwind to bond returns.


1 Based on a decomposition of 2023 returns between returns from yields and returns from changes in interest rates or credit spreads for the Bloomberg US Aggregate Index, Bloomberg US Credit Index, Bloomberg MBS Fixed Rate Index, Bloomberg US Corporate High Yield Index, JPM EMBI Global Index, Bloomberg Municipal Bond Index, and Bloomberg High Yield Muni Bond Index.

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Disclosures

Past performance is not a guarantee or reliable indicator of future results.

All investments contain risk and may lose value. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and low interest rate environments increase this risk. Reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. High yield, lower-rated securities involve greater risk than higher-rated securities; portfolios that invest in them may be subject to greater levels of credit and liquidity risk than portfolios that do not. Asset allocation is the process of distributing investments among various classes of investments (e.g., stocks and bonds). It does not guarantee future results, ensure a profit or protect against loss.

Hypothetical illustrations have many inherent limitations, some of which are described below. No representation is being made that any account will or is likely to achieve results similar to those shown. In fact there are frequently sharp differences between hypothetical results and actual results subsequently achieved by any particular trading program.

One of the limitations of hypothetical results is that they are generally prepared with the benefit of hindsight. In additional, hypothetical scenarios do not involve financial risk, and no hypothetical illustration can completely account for the impact of financial risk in actual trading. For example, the ability to withstand losses or to adhere to a particular trading program in spite of trading losses are material points which can also adversely affect actual trading results. There are numerous other factors related to the markets in general or to the implementation if any specific trading program which cannot be fully accounted for in the preparation of a hypothetical illustration and all of which can adversely affect actual results.

Statements concerning financial market trends or portfolio strategies are based on current market conditions, which will fluctuate. There is no guarantee that these investment strategies will work under all market conditions or are appropriate for all investors and each investor should evaluate their ability to invest for the long term, especially during periods of downturn in the market. Outlook and strategies are subject to change without notice.

Forecasts, estimates and certain information contained herein are based upon proprietary research and should not be interpreted as investment advice, as an offer or solicitation, nor as the purchase or sale of any financial instrument. Forecasts and estimates have certain inherent limitations, and unlike an actual performance record, do not reflect actual trading, liquidity constraints, fees, and/or other costs. In addition, references to future results should not be construed as an estimate or promise of results that a client portfolio may achieve.

Stress testing involves asset or portfolio modeling techniques that attempt to simulate possible performance outcomes using historical data and/or hypothetical performance modeling events.  These methodologies can include among other things, use of historical data modeling, various factor or market change assumptions, different valuation models and subjective judgments. Return assumptions are for illustrative purposes only and are not a prediction or a projection of return. Return assumption is an estimate of what investments may earn on average over the long term. Actual returns may be higher or lower than those shown and may vary substantially over shorter time periods.

Bloomberg U.S. Aggregate Index represents securities that are SEC-registered, taxable, and dollar denominated. The index covers the U.S. investment grade fixed rate bond market, with index components for government and corporate securities, mortgage pass-through securities, and asset-backed securities. These major sectors are subdivided into more specific indices that are calculated and reported on a regular basis. Bloomberg Municipal Bond Index consists of a broad selection of investment-grade general obligation and revenue bonds of maturities ranging from one year to 30 years. It is an unmanaged index representative of the tax-exempt bond market. The index is made up of all investment grade municipal bonds issued after 12/31/90 having a remaining maturity of at least one year. Bloomberg U.S. Credit Index is an unmanaged index comprised of publicly issued U.S. corporate and specified non-U.S. debentures and secured notes that meet the specified maturity, liquidity, and quality requirements. To qualify, bonds must be SEC-registered. This index was formerly known as the Bloomberg Credit Investment Grade Index.. Bloomberg U.S. MBS Fixed-Rate Index covers the mortgage-backed pass-through securities and hybrid ARM pools of Ginnie Mae (GNMA), Fannie Mae (FNMA), and Freddie Mac (FHLMC). The MBS Index is formed by grouping individual fixed rate MBS pools into generic aggregates. The Bloomberg US Corporate High Yield Bond Index measures the USD-denominated, high yield, fixed-rate corporate bond market. Securities are classified as high yield if the middle rating of Moody's, Fitch and S&P is Ba1/BB+/BB+ or below. J.P. Morgan Emerging Markets Bond Index (EMBI) Global tracks total returns for United States Dollar denominated debt instruments issued by emerging market sovereign and quasi-sovereign entities:  Brady bonds, loans, and Eurobonds. It is not possible to invest directly in an unmanaged index. The Bloomberg High Yield Municipal Bond Index measures the non-investment grade and non-rated U.S. tax-exempt bond market.  It is an unmanaged index made up of dollar-denominated, fixed-rate municipal securities that are rated Ba1/BB+/BB+ or below or non-rated and that meet specified maturity, liquidity, and quality requirements.  It is not possible to invest directly in an unmanaged index.

Morningstar Category Index: To create a model for active managers in each Morningstar Category Index PIMCO utilizes a multivariate regression of daily returns on active managers within each Morningstar Category Index versus its category benchmark over the last 10-years ending 30 June 2023 (updated annually) to create a risk model out of key risk factors which are statistically significant. Each risk model is a combination of the benchmark index and the active risk modeled measured described above. Yield for each category is provided by Morningstar as of the month-end stated. For the Multisector Bond and Non-traditional Bond Categories, we use the full category index given the limited passive funds in these categories and lack of appropriate category benchmark. Please contact PIMCO for more details on how each category index model is estimated. For a description of each Morningstar Category please visit: here

©2024 Morningstar. All Rights Reserved. The information contained herein: (1) is proprietary to Morningstar and/or its content providers; (2) may not be copied or distributed; and (3) is not warranted to be accurate, complete or timely. Neither Morningstar nor its content providers are responsible for any damages or losses arising from any use of this information. Past performance is no guarantee of future result

PIMCO as a general matter provides services to qualified institutions, financial intermediaries and institutional investors. Individual investors should contact their own financial professional to determine the most appropriate investment options for their financial situation. This material contains the opinions of the manager and such opinions are subject to change without notice. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. PIMCO is a trademark of Allianz Asset Management of America LLC in the United States and throughout the world. 2024, PIMCO

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