Better early than late
Being defensive in credit may mean a little pain for a bigger potential gain.
Published October 10 2023
Robert Ostrowski, CFA
Executive Vice President
Chief Investment Officer, Global Fixed Income Group
Senior Portfolio Manager
Muni credit remains strong but doesn't insulate investors from market risk
Municipal bonds continue to benefit from solid credit metrics and limited supply as higher rates stall refunding. The economic expansion and accumulated Covid-era transfers have left many state & local governments and revenue bond issuers cash rich with strong balance sheets. However, challenges have emerged. As Treasury yields rose rapidly in the third quarter, municipal yields also increased, producing losses and prompting redemptions from municipal bond mutual funds. A higher-for-longer Fed and still-elevated inflation compound the valuation risks for office real estate in urban municipalities while various revenue bond issuers—airports, toll roads, hospitals and public utility providers—face higher costs and narrower margins. More importantly, we expect the economy to slow and potentially dip into recession, creating challenges across credit markets. That said, the overall higher credit quality and lower default risk of municipal bonds relative to most fixed-income assets may attract investors to the sector should such recession occur. — R.J. Gallo
Seventeen years ago this summer, our fixed income models shifted to a defensive stance on credit over brewing troubles in the nation’s housing, and particularly housing finance, markets. While economic growth at the time was robust, a turn for the worse seemed inevitable. It was. It just took another year to emerge fully. So, for 12 months, we were a bit offsides. But when the economic cracks appeared (ultimately turning into chasms), the market quickly reversed. Our defensive credit position limited risk in our portfolios and helped us to make up the foregone alpha in months.
Why the history lesson? We think we’re setting up for something of a repeat. Nothing like the global financial crisis. But never has the Fed hiked this much this fast without pain. We’ve already had some, in Big Tech (layoffs), housing (buyers can’t find a home or afford a mortgage) and of course, banks. We think the all-important consumer may be next. That’s why we’re staying defensive even at the risk of giving up some short-term alpha. We don’t want to be late in the trades. As 2007-08 suggests, when markets turn, they tend to turn fast and meaningfully. “Defensive” has us underweight most credits, modestly long Treasuries and in a yield-curve steepener which we believe will work whether the economy falters and the Fed eases (a bullish steepener) or chugs along forcing the Fed to hold tight (a bearish steepener).
‘Long and variable lags’ coming home to roost
True, we’ve been cautious all year, only to be surprised by the economy’s consistent strength (September’s nonfarm jobs report the latest example). Consensus has shifted to a “soft landing.’’ But as colleague Don Ellenberger reminds, “Every hard landing starts out as a soft landing,” and the labor market is a lagging, not leading indicator. On a leading basis, two of the historically most reliable signals are screaming recession: a prolonged inversion of the 3-month/10-year Treasury yield curve and 17 straight monthly declines in Conference Board leading indicators.
Moreover, companies needing to refinance will flood the market next year—Goldman Sachs puts the amount at nearly $800 billion and above $1 trillion in 2025, up from an estimated $550 billion this year. Many will represent medium to lower-quality credits (bank loans, high yield) whose costs of financing are 300 to 400 basis points below current market rates. This raises the specter of cash flow difficulties as a jump in credit expenses could cut into margins and earnings. Investment-grade isn’t quite as exposed, in part because its outstanding debt has a longer duration and less refinancing urgency. But potential deterioration looms there too.
Higher for longer has limits
We don’t disagree that rates may be resetting higher, normalizing somewhat to levels that prevailed before the barbell crises (global financial and Covid) that brought 14 years of unprecedented monetary easing. There’s an argument that demographics (retiring baby boomers), record and growing government debt (and the requisite issuance) and a Fed committed to a 2% target create an environment of higher term premia. But there’s a limit to how much higher as inflation finally moderates and the economy slows.
On the positive side of spread markets, we see an idiosyncratic opportunity in MBS, where so much of the market is locked into low-rate mortgages that the negative convexity (in which prices tend to rise less than Treasuries when rates fall and fall more when rates rise) typically associated with the mortgage market has largely been exhausted. This offers investors the potential to buy at a discount into a market where yields already tend to run higher than Treasuries. With the spread between mortgages and Treasuries in the 91st percentile going back 15 years, it’s an opportunity we believe is too attractive to pass up.