Time, we believe, is on our side Time, we believe, is on our side http://www.federatedhermes.com/us/static/images/fhi/fed-hermes-logo-amp.png http://www.federatedhermes.com/us/daf\images\insights\article\clocks-antique-beach-small.jpg July 13 2023 July 11 2023

Time, we believe, is on our side

Defensive positioning didn’t hurt the first half. In the second half, it may help.
Published July 11 2023
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Munis post favorable returns in uncertain environment

Given their high quality—the average credit rating is AA—and elevated yields relative to the last 10 years, municipal bonds continue attract investors in a challenging environment. While the strength of economy surprised in the first half, it nonetheless is exhibiting signs of deterioration. While an eventual recession remains our base case, abetted by a Fed that appears committed to higher for longer, it would occur at time of strong credit conditions for most state and local governments. Many state and local entities are cash rich because of large federal Covid-relief transfers and strong tax revenues during the economic expansion. To be sure, some states are starting to see sequential declines in income tax revenues, while bank stress and declining office real estate values represent additional headwinds. These risks to date remain manageable, while low new issuance and solid demand has supported favorable, modestly positive municipal bond returns through the first half of 2023. — R.J. Gallo

From a big picture perspective, 2023’s first six months played out largely as we previewed at the start of the year. The thinking then was that even though the Fed should remain in play throughout this year, the bulk of market effects from one of the most dramatic tightening cycles in history already had been experienced. This led us to begin the year with a more constructive view on fixed income after being defensive throughout 2022’s historic bear market with its double-digit negative total returns. At the headline level, that call has been roughly on target, with the Bloomberg, S&P and other U.S. aggregate returns in the 2-2.50% range in the first half, when the 10-year Treasury yield slipped just 4 basis points to 3.84%. Nothing dramatic, and nothing like 2022, when the 10-year more than doubled, soaring 237 basis points to close at 3.88%.

Underneath the hood, however, it’s been a different story. Far from beginning to normalize as the end of the Fed’s tightening cycle grew closer, a yield curve that started the year inverted, inverted even further. In the credit space, where our sector committee was underweight investment-grade (IG) and high-yield (HY) corporate bonds on expectations of a slowing economy, spreads (the yield gap relative to comparable maturity Treasuries) narrowed, returning slightly more than 3% and 5%, respectively. The good news is both our rate and credit bets were relatively small. So, combined with solid performances in EM and mortgages—two sectors where we had above-benchmark exposure—along with strong security selection within IG and HY, our strategists “kept us in the game,’’ if you will, allowing the majority of our strategies to be competitive with their benchmarks through June.

Sticking with our bets on rates …

Where do we go from here? We’re sticking with our broader bets. On rates, with markets priced for continued labor market strength, sticky inflation and some additional Fed hikes, the larger risk to us is a potential asymmetrical move down on any material softening in the labor market or inflation data. History tells us when such moves come, they tend to come quick and violently. This view has us entering the second half modestly long duration (105% of neutral) in our models, with a small steepener in the 2-year/10-year and 5-year/30-year sections of the Treasury yield curve. The latter reflects the severe cheapening in 2-year and 5-year Treasury yields, which ended June at 4.90% and 4.15%, respectively, just off March’s cycle highs and in line with pre-global financial crisis levels. Hard to see either cheapening much further from current levels.

… and credit

The string of upside surprises in the economy made for what Federated Hermes Senior Portfolio Manager John Sidawi called a “consensus killer’’ first half. We aren’t expecting a repeat. The economic headwinds are growing and many. Higher costs of capital due to aggressive Fed tightening. Muted bank lending activity. Weakening commercial real estate markets. Fiscal spending restraints. Fading corporate profit growth. A consumer facing dwindling excess savings and the resumption of required federal student loan payments averaging nearly $400 a month. Recent ISM and PMI data suggest manufacturing is contracting, Conference Board leading indicators have been negative 14 straight months and June’s nonfarm payroll gains were the smallest since December 2020’s decline. With the economy and credit conditions likely to deteriorate, it’s hard to be constructive on IG and HY. We think EM will offer more opportunities before year-end, but took profits in late June, shifting from overweight to neutral. Wide spreads, low prepayment risks, attractive yields and rising flows are keeping agency MBS our biggest overweight.

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DISCLOSURES

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.

Past performance is no guarantee of future results.

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.

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.

Purchasing Managers’ Index (PMI) is an index of the prevailing direction of economic trends in the manufacturing and service sectors.

S&P U.S. Aggregate Bond Index: A measure of the performance of publicly issued U.S. dollar denominated investment-grade debt, including U.S Treasuries, quasi-governments, corporates, taxable municipal bonds, foreign agency, supranational, federal agency, and non-U.S. debentures, covered bonds, and residential mortgage pass-throughs. Indexes are unmanaged and investments cannot be made in an index.

The Conference Board's Composite Index of Leading Economic Indicators is published monthly and is used to predict the direction of the economy's movements in the months to come.

The Institute of Supply Management or ISM nonmanufacturing 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.

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.

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