Bond clouds starting to part Bond clouds starting to part\images\insights\article\storm-clouds-serengeti-small.jpg November 1 2022 October 12 2022

Bond clouds starting to part

With peak yields in sight, better times may be too.

Published October 12 2022
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Views on munis improving

This year’s run-up in yields pressured bonds and municipal securities were no exception. The S&P Municipal Bond Index returned -3.40% in the third quarter, with the weakest performance coming in longer-dated issues. Muni fund redemptions also remained robust. The good news is munis have cheapened enough to offer a much-improved risk/return balance for investors. At this writing, the 30-year BVAL AAA muni yield was 3.85% versus 1.54% at year-end 2021. Further, market yields arguably are nearing a peak on rising recession risks and a Fed that’s closing in on an end to its aggressive rate-hike cycle (forward markets suggest a terminus next spring). While elevated inflation and slowing economy present challenges, particularly in revenue bond segments of the municipal market (airports, toll roads, hospitals, public water/sewer and public power), state and local finances are strong, as are muni credit fundamentals. Combined with credit spreads that are cheaper and initial yields that are higher, all this suggests munis offer attractive near-term value. Whether it’s compelling enough relative to Treasuries and investment-grade corporates that labor under similar forces is the question.—R.J. Gallo

No sugarcoating 2022—the worst for bonds since the 1790s, a Santa Clara University business professor says. The broad Bloomberg US Aggregate Bond Index returned -14.6% through September, a record decline for the first nine months. The “safer” Bloomberg US Treasury Index returned -13.1%. The good news: The Fed’s recent hawkish policy stance helps ensure that relief is on the way. A significantly higher starting point on income (September breached 4% on the 10-year Treasury yield and the 4.5% yield-to-maturity on the Agg likely isn’t far from where yields may peak), and a market that is discounting future Fed increases and a possible recession, create the potential for positive total returns going forward. Will rates stabilize or decline by year-end? Possibly. Not ready to make that call yet.

First, we need more clarity on how much “pain,” as Chair Powell put it, the Fed inflicts. It seems certain to keep hiking into the new year and to hold tight once it gets where it wants to be (we’re thinking a terminal rate around 4.50%). Policy rates already have jumped a Volckeresque 300 basis points off mid-March’s zero-bound, and both September Fed projections and futures indicate additional increases of 125 points by early 2023. Despite wishful risk-market whispers of a pause or slowing, Fed policymakers keep pounding their hawkish message. They’re determined to get inflation down toward their 2% target, and the bond market is taking them at their word. The TIPS 5-year breakeven rate ended Q3 at a 20-month low 2.15%, and almost all the Treasury curve has inverted.

It's all about “sticky” inflation …

As long as core rates keep running hot, the Fed arguably has a single mandate, and it will be challenging. Rents, which account for about a third of CPI, accelerated in August, lifting core CPI to a 5-month high. Wages keep rising at nearly a 7% annualized rate, the fastest in the nearly 26-year history of the Atlanta Fed’s wage-growth tracker. With home prices near record highs and the labor market still historically tight, these two structural forces are unlikely to rapidly reverse. It doesn’t help that food prices remain a problem. In August, they posted their biggest 12-month increase since May 1979. Energy, too. As the world’s second- and third-largest producer of natural gas and oil, respectively, Russia is utilizing its pricing and production to weaponize the resources and keep prices near their cycle highs. Last week’s decision by OPEC+ to cut oil production is one example.

… even at a cost of possible recession

Rate increases, which hit with a lag, have started to bite in an economy already struggling with pandemic-related supply shortages and fallout over Russia’s invasion of Ukraine. Along with record prices, a doubling in mortgage rates has sent rate-sensitive home sales plunging, and home construction is slowing, too. Manufacturing and services activities are decelerating, and forecasting firms are sounding recession alarms. A big offset: a strong jobs market, though it is starting to show cracks. August saw the biggest drop in job openings since the pandemic’s start. Still, there were 1.8 openings for every unemployed person, and even if the jobless rate rises to 4.4% next year, as the Fed projects, it would be historically low. Consumer and corporate balance sheets are in good shape, too. Nothing like typical pre-recession stress levels. These counterbalances suggest a recession, though a relatively high probability, is likely to be less severe than the ’20 Covid recession or the ’08 financial crisis.

Cautious on credit; potential in Treasuries

  • After adding significant value by being overweight credit in the 18 months after Covid hit, the last nine months of stagflation have led our models to underweight high yield, investment grade (IG), commercial MBS and less so emerging market debt on concerns about further spread widening, weakening macro conditions and rising defaults. That said, underlying credit conditions remain relatively healthy, with marginal rate exposure among the vast majority large-cap companies (ex-financials and real estate), and spreads nearing an end point that would argue for adding exposure. Just not yet.
  • Within our broad credit underweights, there may be selective value in lower quality credits (BBB and financials in IG, mid- to higher-spread issuers in high yield) because of strong underlying credit conditions and earnings that may slow but remain largely OK for bond investors. With a nod toward potential countervailing effects from a slowing economy, shorter-term floating-rate loans and municipal securities also offer value. Low-duration strategies should benefit relative to long-duration instruments but confront challenges from persistent increases on the short end. For instance, in the 1- to 5-year government/credit space, investors can get nearly all the forward-looking yield with only 60% of the interest-rate volatility of a core-duration portfolio. This works well in a low volatility/stable yield-curve environment, albeit relatively less so if the market experiences further inversion.
  • While interest-rate volatility may continue, by definition we are closer to the end than the beginning of the rate cycle. We think the mortgage market, which already is priced to a high level of rate volatility, presents opportunities. (An overweight to mortgages in July generated a large contribution to our multi-sector strategy performance that we subsequently took profits on before the market turned negative again in August/September.) At present, we are again overweight this asset class on spread valuations, although not yet at max, as the challenging issue of finding buyers in a market where the Fed has pulled back still exists.
  • Treasuries and agencies merit monitoring on the belief we’re closing in on peak yields. Even if yields keep rising, there is now at least a reasonable level of income to offset potential price declines while the potential for price increases improves as the Fed gets closer to its terminal rate.

Rate strategies sniffing an end point

The face-off between the Fed and inflation has created a dichotomy for rate positioning, with a higher terminal rate competing with the outcome, i.e., a slowing economy and possible recession. Duration has generated a significant amount of alpha year-to-date in our model portfolios, which were mostly short the first half of 2022 as rates rose and have been hovering at or near neutral since as rates have been somewhat rangebound. A falloff in economic activity that slows inflation as much as forward markets seem to think will occur raises the potential for going long. With the Fed and European central banks in the middle of aggressive rate-hike cycles, a flatter to more inverted yield curve is the base call for yield-curve positioning, although this position is also becoming “late in the game.” The dollar has risen so dramatically that the best opportunities may lie in tactical shorts against this one-way trade, or in currency pairs within specific markets.

Tags Fixed Income . Markets/Economy . Active Management .

Views are as of the date above and are subject to change based on market conditions and other factors. These views should not be construed as a recommendation for any specific security or sector.

Alpha shows how much or how little return is generated, given the risk a portfolio takes. A portfolio with an alpha greater than 0 has earned more than expected given its beta—meaning the portfolio has generated excess return without increasing risk. A portfolio with a negative alpha is producing a lower return than would be expected given its risk.

Bloomberg’s Evaluated Pricing Product (BVAL) provides yields across more than 600 corporate and government sectors, including AAA-rated municipal bonds.

Bloomberg US Aggregate Bond Index: An unmanaged index composed of securities from the Bloomberg Government/Corporate Bond Index, Mortgage-Backed Securities Index and the Asset-Backed Securities Index. Total return comprises price appreciation/depreciation and income as a percentage of the original investment. Indices are rebalanced monthly by market capitalization. Indexes are unmanaged and investments cannot be made in an index.

Bloomberg US Treasury Bond Index is part of Bloomberg Capital global family of government bonds indices. The index measures the performance of the U.S. Treasury bond market, using market capitalization weighting and a standard rule based inclusion methodology. Indexes are unmanaged and investments cannot be made in an index.

Bond credit ratings measure the risk that a security will default. Credit ratings of A or better are considered to be high credit quality; credit ratings of BBB are good credit quality and the lowest category of investment grade; credit ratings of BB and below are lower-rated securities; and credit ratings of CCC or below have high default risk.

Bond prices are sensitive to changes in interest rates, and a rise in interest rates can cause a decline in their prices.

Diversification and asset allocation do not assure a profit nor protect against loss.

Effective Duration: A measure of a security’s price sensitivity to changes in interest rates. One of the methods of calculating the risk associated with interest rate changes on securities such as bonds.

High-yield, lower-rated securities generally entail greater market, credit/default and liquidity risk and may be more volatile than investment-grade securities. For example, their prices are more volatile, economic downturns and financial setbacks may affect their prices more negatively, and their trading market may be more limited.

International investing involves special risks including currency risk, increased volatility, political risks, and differences in auditing and other financial standards. Prices of emerging-market and frontier-market securities can be significantly more volatile than the prices of securities in developed countries, and currency risk and political risks are accentuated in emerging markets.

Municipal bond income may be subject to the federal alternative minimum tax (AMT) and state and local taxes.

S&P Municipal Bond Index (formerly S&P/Investortools Municipal Bond Index): Is a broad, comprehensive, market value-weighted index composed of approximately 55,000 bond issues that are exempt from U.S. federal income taxes or subject to the alternative minimum tax (AMT).

The value of some mortgage-backed securities may be particularly sensitive to changes in prevailing interest rates, and although the securities are generally supported by some form of government or private insurance, there is no assurance that private guarantors or insurers will meet their obligations.

Yield Curve: Graph showing the comparative yields of securities in a particular class according to maturity. Securities on the long end of the yield curve have longer maturities.

Yield to Maturity (YTM): Used to determine the rate of return an investor would receive if a long-term, interest-bearing investment, such as a bond, is held to its maturity date. It takes into account purchase price, redemption value, time to maturity, coupon yield, and the time between interest payments.

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