Picking our spots Picking our spots http://www.federatedhermes.com/us/static/images/fhi/fed-hermes-logo-amp.png http://www.federatedhermes.com/us/daf\images\insights\article\feet-and-two-arrows-painted-on-floor-small.jpg May 30 2023 April 14 2023

Picking our spots

Volatile markets can offer opportunities.

Published April 14 2023
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Munis generally in a good place as storm clouds build

Municipal market yields nearly kept pace with declining Treasury yields in the first quarter as investor demand was robust and muni supply remained muted. The stress in the banking sector that prompted strong returns for high quality fixed income, including munis, likely will contribute to downside risk for the U.S. economy in coming months. Fortunately, munis as a group are approaching the likely economic slowdown or recession from a position of relative strength.  In fact, some of the highest profile mid and lower quality governmental borrowers in the market, including the states of Illinois and New Jersey as well as the Chicago Board of Education, were recently upgraded. This is reflective of the broad trend toward stronger balance sheets for many state and local governments—an outgrowth from the large federal Covid relief packages, strong tax revenues arising from the economic expansion and rising property values in much of the country. There are lurking risks, however. The likely decline in commercial real estate valuation in coming years will erode local tax bases in certain areas of the country and a U.S. recession would certainly depress state income & sales tax revenues. — R.J. Gallo

Volatility was the name of the game on both rates and spreads (rate differentials relative to Treasuries) in Q1. In the first two months, markets grappled with the remnants of the prior 10 months’ historic pace of Fed rate hikes, and then in March dealt with a large consequence of those hikes: a regional banking crisis. Because we took profits in late 2022 on our shorter duration and yield-curve inversion calls, Federated Hermes fixed income portfolios “locked in” much of their relative outperformance over the prior eight consecutive quarters. By sticking with an underweight to corporate bonds hedged to some degree with overweights to EM and U.S. agency MBS, this positioning also helped generate positive returns in line with the Bloomberg US Aggregate and US Universal Bond indexes in the first quarter.

Looking forward, with investors torn between the Fed’s insistence on further rate hikes and a market haunted by visions of 2008 insisting maybe not, we continue to position cautiously. That means neutral across most of our fixed-income franchise, be it rates or sector, with no outsized bets either way. We again enter a new quarter with continued below-benchmark exposure to investment-grade (IG) and high-yield corporates (though minimally so on IG), a slightly larger overweight to EM where a near double-digit coupon justifies the additional spread risk, and a larger overweight to MBS where prepayment risks are almost nil, inventories are extremely tight and wide spreads present opportunities.

In other words, we’re picking our spots in a market that, except for a spike in the early stages of the pandemic, hasn’t been this volatile since the global financial crisis. With the Fed raising policy rates at its fastest pace in history, causing Treasury rates to soar in step and the yield curve to massively invert, there’s always the fear that something may break. Was the banking panic spawned by the second- and third-largest bank failures in U.S. history, followed days later by the forced marriage of global giant Credit Suisse with even larger Swiss megabank UBS, a sign of much worse things to come in the sector? Our strategists don’t think so. But while the banking panic appears to be subsiding, its ripples haven’t ended yet. We still need to see how this plays out.

In the meantime, the latest economic data (the smallest increase in nonfarm payrolls since December 2020, the slowest pace of job openings in 21 months, the lowest manufacturing ISM reading since May 2020) suggest the economy is slowing. Prices, while elevated, look to be easing, too. Will this, and the banking turmoil, be enough to put the Fed on pause? We’re more skeptical than the markets but are somewhat uncertain about what happens in late summer and fall. Some market participants expect a potential quarter-point cut or two by year-end. Others see policymakers holding steady. Either would suggest we’re nearing if not already at “peak Fed,” which is supportive of our 5-year/30-year steepener call on the Treasury curve. Might a 2/10-year bull steepener be next?

That answer depends on what the Fed and economy do next. With the 2-year already having rallied 110 basis points off its mid-March high, a lot of “peak Fed” arguably is already priced in. And if the economic data continues to soften, recession worries could take the 10-year lower. Not sure a steepener (that’s the consensus call and we’re never comfortable being with consensus) would work there. In fact, we’re holding duration at neutral for now in part because we think the 10-year’s nearly 60 basis-point drop on the banking panic may have overshot the fundamentals. With wage growth greatest at the lower end of the income spectrum, excess savings greatest at the higher-income end and both corporate and household balance sheets still relatively healthy, there are a lot of underlying positive economic forces still at work. But rate increases tend to hit with significant lags (how much is debatable—has the historic 12-to-18 months shrunk to nine-to-12 months in this rapidly moving global economy?), suggesting impacts from the past year’s record tightening are just starting to take root. Hard to say with conviction which way things may break. So, until we get better clarity, we’re picking our spots.

Tags Fixed Income . Markets/Economy . Interest Rates .

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.

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 Universal Index: Is an index that represents the union of the US Aggregate Index, US Corporate High-Yield, Investment Grade 144A Index, Eurodollar Index, US Emerging Markets Index and the non-ERISA eligible portion of the CMBS Index. The index covers USD denominated, taxable bonds that are rated either investment grade or below investment grade.

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.

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.

The Institute of Supply Management (ISM) manufacturing index is a composite, forward-looking index derived from a monthly survey of U.S. businesses.

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.

Federated Investment Management Company