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Valuations Matter in the Bond Market Too

Valuations Matter in the Bond Market Too

April 20, 2021
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“Price is what you pay; value is what you get.” – Legendary value investor Ben Graham.

Valuations matter—at least in the long run. We believe it to be true in the equity markets and in the fixed income markets as well. What you pay for an asset ultimately impacts your returns. So when looking at markets, we use, among other things, market-based metrics to help determine valuations. Within fixed income, while we don’t have the various price ratios, for example, to help guide the valuation conversation like equity investors do, we do have yield and spread measures. Two common metrics that we use include Yield-to-Worst (YTW) and Option-Adjusted-Spread (OAS).

YTW is the yield an investor can expect to earn either over the maturity of the bond’s life or until the bond is called away, assuming it doesn’t default first. OAS is the yield premium of owning a bond considered riskier than a U.S. Treasury security (remember that U.S. treasuries are considered one of the safest assets in the world). YTW allows us to determine the expected return of an asset, whereas OAS allows us to determine if we are being fairly compensated for taking on the additional risk.

“Certain areas of the bond market are generally expensive. Instead of taking on additional credit risk in our bond allocations, we think an overweight to equities makes sense because of the potential for higher returns,” according to LPL Financial Chief Market Strategist Ryan Detrick.

So what are we seeing today in terms of valuations? Bond yields remain low but they are getting higher, which helps impact the relative attractiveness of fixed income broadly. Starting yield levels are still the best predictor of future returns: As yields increase, future returns start to look more attractive—at least from a valuation perspective. However, as shown in the LPL Chart of the Day, the additional compensation for holding riskier fixed income assets are at very low levels. In fact, since 2010, the additional risk premium above Treasury securities has rarely been lower. For High Yield in particular, with OAS levels as low as they are, the yield premium over Treasury securities may not be worth taking on the additional credit risk (subject to investor risk tolerances and return needs). From a valuation perspective, it’s difficult to get excited about any of the broad sectors in general—we’re still positive on mortgage-backed securities (MBS) for their defensive properties during rising interest rate environments; however, valuations are stretched here, too.

View enlarged chart.

Valuations are a core component of our research process, but we acknowledge that they aren’t the only thing that matters. We also look at fundamentals and technicals when evaluating the attractiveness of various investments. So, while valuations are stretched across a number of fixed income markets, the fundamental landscape for credit markets remains favorable. Additionally, the continued search for yield will likely remain a technical tailwind to non-Treasury assets; however, given very low starting yield levels and stretched valuations, investors should expect low returns within their fixed income allocations for the foreseeable future.

 

IMPORTANT DISCLOSURES

This material is for general information only and is not intended to provide specific advice or recommendations for any individual. There is no assurance that the views or strategies discussed are suitable for all investors or will yield positive outcomes. Investing involves risks including possible loss of principal. Any economic forecasts set forth may not develop as predicted and are subject to change. References to markets, asset classes, and sectors are generally regarding the corresponding market index. Indexes are unmanaged statistical composites and cannot be invested into directly. Index performance is not indicative of the performance of any investment and do not reflect fees, expenses, or sales charges. All performance referenced is historical and is no guarantee of future results. Any company names noted herein are for educational purposes only and not an indication of trading intent or a solicitation of their products or services. LPL Financial doesn’t provide research on individual equities. All information is believed to be from reliable sources; however, LPL Financial makes no representation as to its completeness or accuracy. U.S. Treasuries may be considered “safe haven” investments but do carry some degree of risk including interest rate, credit, and market risk. They are guaranteed by the U.S. government as to the timely payment of principal and interest and, if held to maturity, offer a fixed rate of return and fixed principal value. All index and market data from FactSet and MarketWatch. This Research material was prepared by LPL Financial, LLC. Securities and advisory services offered through LPL Financial (LPL), a registered investment advisor and broker-dealer (member FINRA/SIPC). Insurance products are offered through LPL or its licensed affiliates.  To the extent you are receiving investment advice from a separately registered independent investment advisor that is not an LPL affiliate, please note LPL makes no representation with respect to such entity.

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