Fixed Income Investing in US Recessions

In brief

• Fixed income has outperformed both cash and equities during recessions in the US since 1972.
• Interest rates tend to begin to decline three months ahead of recessions and reach a cycle low about five months into recessions.
• During economic downturns, fixed income has been shown to provide diversification benefits and reduce the volatility of portfolios that include risk assets such as equities. 
  

Since the beginning of 2022, much of the investment universe has been upended as central banks around the world have worked to rein in multi-decade high inflation by raising interest rates and  through a reversal of quantitative easing. The magnitude of financial tightening in this cycle — the US Federal Reserve’s policy rate has risen from 0.25% to 5.50% — has historically coincided with US economic recessions. While there is still debate over whether a recession is approaching, investors might want to consider how fixed income has performed during economic downturns in the past. In fact, according to our historical analysis, it has outperformed and significantly reduced portfolio volatility during periods of stress. 

Defining Recessions

There have been eight recessions (as defined by the National Bureau of Economic Research) in the  United States since 1969. We put them into two categories: mild and severe. Severe recessions have  three qualities:

Recessions that do not have these characteristics fall into the mild recession category. Since 1969 there have been four severe and four mild recessions. Many began at the end of monetary tightening cycles initiated by the Fed, which, along with other central banks, tends to engage in countercyclical monetary policy, trying to tighten financial conditions when the economy is running too hot or heat up the economy when it has cooled down too much. For fixed income and rate-sensitive products, that generally means an increase in rates during the tightening cycle leading into recession and then a decline in rates as the Fed cuts its policy rate to stimulate economic activity.

Rate movements before and after recessions

Exhibit 1 traces the average path of US 10-year Treasury rates 12 months before and 12 months into both mild and severe recessions.

We find that rates tend to take a similar path during mild and severe recessions, rising leading into recession and falling as the recession lands. Rates tend to peak three months before the recession before declining, bottoming four to five months into the recession on average. For severe recessions, rates decline nearly 70 basis points on average, somewhere between three months prerecession and four months into recession. In mild recessions, rates tend to rise longer, typically peaking in the first month, and declining through the fifth and sixth. In mild recessions, on average, rates decline 93 bps through the first and fifth months of recession. Not including the 1980 recession, during which rates fell precipitously from a high base, mild recessions decline an average of only 55 bps.

Treasury performance through recessions

While recessions are challenging for investors, declining interest rates can be beneficial to the fixed income segment of a diversified investor’s portfolio. Looking at three- and six-month returns for US Treasury bonds, we have found the low point in performance occurs roughly three months prior to recessions while peaks in Treasury bond performance occur roughly five months into them.

Exhibit 2 : Average US Treasury returns during recession

While the returns shown above illustrate how fixed income performance picks up during a recession, this analysis is done with the benefit of hindsight, because we know the start and end dates of the recessions we look at. To predict the timing of a future recession, investors need to look for signals.

One useful signal is the Conference Board’s US Leading Indicator Index (LEI) which aggregates several economic indicators that tend to lead the business cycle. Since 1973, the LEI has fallen below zero on ten occasions, seven of which led to recession. The three false signals were characterized by a single monthly reading below zero before the index rebounded. Therefore, any sustained drop below zero is a strong indication that a recession may be on the horizon. Of the seven readings that foretold a recession, on average the LEI index began to roll over six months prior to the recession and bottomed roughly 14 months into it. This time horizon overlaps closely with the peak and subsequent decline observed in interest rates. Exhibit 3 shows the annualized performance of the US Treasury index beginning when the LEI first went negative and ending at its recessionary trough. On average, Treasuries have returned 14.4% during these LEI drawdowns. This suggests that when paired with risk assets like equities, which tend to have less favorable performance during recessionary periods, fixed income can help manage downside risk during downturns.

Relative performance against other asset classes

It is instructive to compare fixed income to other asset classes from a strategic asset allocation perspective, i.e., how it can be utilized most effectively in a portfolio. 

Recent central bank rate increases have made cash an attractive investment for the first time in many years, and fixed income typically underperforms cash during rate hiking cycles, as shown in Exhibit 4. However, based on historical analysis, once central banks hike for the final time in the cycle, to what is called the terminal policy rate, bonds are well positioned to benefit from subsequent rate cuts and have historically outperformed cash investments during and after terminal rate periods.

In contrast to fixed income, which receives a tailwind from central banks during declines in economic activity, equities have generally underperformed. Exhibit 5 compares Treasuries to US equities during recessionary periods since 1972. In each case, Treasury bonds have a lower drawdown and have recovered more quickly. Of the seven recessions shown, US Treasury bonds have an average recession maximum drawdown of 3.6%, with an average recovery period from the initial drawdown of ten months. This compares with an average equity maximum drawdown of 38.4% and a recovery time of 44 months, or a little over 3.5 years.

Diversification benefits

While drawdowns have been milder and recoveries quicker for fixed income, government bonds have also provided positive returns during recessions. Exhibit 6 highlights the divergence in government bonds and equity returns during periods of market stress, further demonstrating the diversification benefits of fixed income, which can help manage downside risk.

This relationship was tested in 2022, when the world economy was facing levels of inflation last seen in the 1980s, and mammoth monetary tightening was enacted in very short order in response to it (Exhibit 6).

Correlations between equity and fixed income can shift before and after a recession. As seen in Exhibit 7, the last four recessions have typically seen correlations between Treasuries and equities peak several months before the recession has begun and decline into and during the recession. Across all the recessions examined, we see tangible declines in correlation, with some of the severe recessionary episodes such as 2008 showing significant declines.

The decline in correlation often benefits investors’ portfolios as a lower correlation has generally resulted in lower overall portfolio risk. For example, an investor with a portfolio of 60% stocks with a volatility of 20%, and 40% bonds with a volatility of 5%, would see their overall portfolio risk decline by 70 bps if the correlation declines by 0.35 points. This bolsters the case for fixed income given its excellent diversification and risk reduction benefits at the portfolio level.

Impact of fixed income in portfolios

How much fixed income is appropriate for a given portfolio? Every investor’s objective and risk tolerances differ; however, we believe greater allocations to fixed income going into a recession generally helps to manage downside risk throughout the recession relative to portfolios with a higher allocation to equities. Exhibit 8 compares the monthly drawdowns of three hypothetical portfolios, ranging from 20% fixed income to 60% fixed income.

Exhibit 8: Hypothetical portfolio performance during recession

As can be seen above, in each hypothetical portfolio the maximum drawdown for US equities was much  larger than that of US Treasuries and higher allocations to fixed income provided less volatility. Also, as Treasury performance has historically turned positive well before equities, we believe an investor may benefit from rebalancing portfolios back to the target allocation, buying into equities at a time when they are more likely to do well going forward, which can place a portfolio in a stronger position for the next beginning of a business cycle. 

In conclusion

While every recession is different, we believe the benefits of fixed income in recessionary periods will  continue to be seen in the future. As central bank hiking and cutting cycles continue, we expect that the historical pattern of rates rising into a recession, falling just prior, and continuing to fall into the first four to five months of recessions is likely to continue. We also expect that many of the diversification and risk reduction advantages of fixed income relative to equities will continue to potentially benefit investors during economic downturns. If the dark clouds of recession are indeed brewing, an allocation to fixed income is an important tool for investors to consider.

Source: Bloomberg Index Services Limited. BLOOMBERG^_® is a trademark and service mark of Bloomberg Finance L.P. and its affi liates (collectively “Bloomberg”). Bloomberg or Bloomberg’s licensors own all proprietary rights in the Bloomberg Indices. Bloomberg neither approves or endorses this material or guarantees the accuracy or completeness of any information herein, or makes any warranty, express or implied, as to the results to be obtained therefrom and, to the maximum extent allowed by law, neither shall have any liability or responsibility for injury or damages arising in connection therewith.

“Standard & Poor’s^_®” and S&P “S&P^_®” are registered trademarks of Standard & Poor’s Financial Services LLC (“S&P”) and Dow Jones is a registered trademark of Dow Jones Trademark Holdings LLC (“Dow Jones”) and have been licensed for use by S&P Dow Jones Indices LLC and sublicensed for certain purposes by MFS. The S&P 500^_® is a product of S&P Dow Jones Indices LLC, and has been licensed for use by MFS. MFS’ Products are not sponsored, endorsed, sold or promoted by S&P Dow Jones Indices LLC, Dow Jones, S&P, or their respective affi liates, and neither S&P Dow Jones Indices LLC, Dow Jones, S&P, their respective affiliates make any representation regarding the advisability of investing in such products.

The views expressed herein are those of the MFS Investment Solutions Group within the MFS distribution unit and may differ from those of MFS portfolio managers and research analysts. These views are subject to change at any time and should not be construed as the Advisor’s investment advice, as securities recommendations, or as an indication of trading intent on behalf of MFS.