What Would You Say to Investors Who Are Still Sitting on the Sidelines?
This has been a very difficult year for fixed income investors. But we think the bond market is looking increasingly attractive here. Bond investors are getting yields that we haven't seen in 20 years, outside of the global financial crisis. Rising yields are painful for bond investors in the short term, but it puts you in a much better position to generate positive returns going forward. Since the start of the year, we've seen a huge increase in yields. Yields are higher, on average, by over 300 basis points for the Bloomberg Aggregate. And for the high yield market, yields are up by more than 500 basis points. We think this provides an important cushion against rising rates.
One way to think about this is: how much can yields rise to breakeven – that is, have a flat return over a one-year holding period. So take, for example, a five-year Treasury that currently yields around 4.5% with a four-year duration. That bond can rise roughly 100 basis points in yield and still have a flat total return if you hold it over 12 months. At the start of the year, that breakeven was only about 28 basis points. And for shorter maturity Treasuries, the breakeven right now is even higher. And, for an average BB high yield bond, that one-year breakeven is now 170 basis points. So, mechanically and mathematically, bonds look more attractive. But it still comes down to where do yields go from here? We think that, by far, most of the damage has been done. So of course, there are no guarantees. But we think the bond market is setting up for potentially better returns going forward. And in the meantime, we think you're getting paid to wait.
The Fed Has Battled Inflation with Six Rate Hikes This Year. What’s Next?
We said back in January that how the Fed reacts to inflation would be the big driver of financial markets this year. That's how it turned out and we don't see that dynamic changing anytime soon. We have high conviction that inflation is going to come down and probably sharply. But when this shows up in the official inflation measures is a bit more uncertain.
Broadly speaking, we are framing the inflation discussion around goods prices, which are stabilizing or declining, and services prices, which remain stubbornly high and are accelerating in some cases. We are seeing some downward price pressures from a couple of sources. The first is from healing supply chains where ocean freight rates have come down and delivery times are improving. The second is from unwanted inventory bills, such as used car prices. These are still up 50% over pre-pandemic levels and they have been having an outsized contribution to the CPI (Consumer Price Index). Those prices are starting to roll over quickly as semiconductor shortages ease and new car production comes online. Clothing prices are also leveling off and companies like Target and Walmart have said they are sitting on a lot of unsold inventory and need to cut prices to move it.
Service prices, however, are a different story. Airfare and restaurant prices remain elevated, with the latter rising at the fastest rate since the early 1980s. But the big one is shelter, which accounts for about 1/3 of the CPI. Shelter prices have been persistently high and unexpectedly accelerated in September. But we think this is a question of when, not if, falling shelter prices start to show up in the official inflation data. Bottom line, we think inflation is poised to roll over. Forward-looking, market-based indicators – like the TIPS (Treasury Inflation-Protected Securities) market – are also signaling that inflation expectations are coming down.
How Might the Fed React Going Forward?
There is nothing in the current inflation data that's going to slow down the Fed for now. The Fed just did another 75-basis-point hike in early November and the market's also pricing in a better than 50/50 chance of another 75-basis-point hike in December. We're not completely sold on the December hike quite yet, but it'll be close. We think by year-end we'll be seeing enough of a downshift in inflation that the Fed can at least start to dial back its aggressive rate path, and that could give the market some relief.
Do You Believe a Recession Is Likely to Take Place in the US?
This may be the most anticipated recession of all time. We don't believe that a downturn, or certainly a severe downturn, is a foregone conclusion for the US. We do recognize, though, that the combination of an aggressive Fed and stubbornly high inflation does raise the odds of a recession. It's hard for us to see a downturn near term because the economy still has a lot of momentum: the job market is healthy, incomes are rising, consumer balance sheets are strong, and banks are in good financial shape.
The main risk for a downturn is whether the Fed can get it right. Can they engineer a smooth landing by slowing inflation but not crashing the economy? That's challenging because we know that monetary policy works with a lag and raises the potential for the Fed to overdo it. We think recession risk – whether we get one or not – is going to play out in the labor markets, and labor markets have been strong. The US has generated an average of 350,000 jobs per month in the past quarter. That's twice the pace of job creation in the 12-month period leading up to the pandemic and good news for workers. The bad news is that this concerns the Fed because the unemployment rate, at 3.5%, has barely budged, even after 300 basis points of Fed tightening. Wages are running 5%, 6% a year and the Fed is worried that wage growth is being passed through to higher prices and that higher wages are boosting consumer spending and demand. So the Fed wants this wage price cycle to slow or reverse. We think this is starting to happen, although very slowly, but have seen some high-profile job freezes or layoffs at companies like Peloton, Nike, and Amazon.
How Are You Viewing Core Sectors?
We have two big building blocks for our strategy. The first block is the core sectors, which represent the in-benchmark sectors of the Bloomberg Aggregate, which is a high quality, AA-rated, 70% government bond index. The second block is the out-of-benchmark plus sectors, which include high yield, high yield bank loans, foreign currency denominated bonds, or Treasury Inflation-Protected Securities (TIPS).
We allocate between the core and plus sectors, based on our view of where we are in the credit cycle, as well as relative sector valuations. Philosophically, when we believe we're in late cycle, we are likely to have a higher allocation to core sectors, higher quality, more Treasuries, less credit, and higher liquidity. When we're in recovery or early to mid-expansion, we want to shift to the higher yielding, potentially higher return plus sectors.
Our view is that we are in late cycle with growing recession risk, although recession is not our base case. We also believe we are nearing the peak in interest rates and that yields have room to fall. So we have been looking to upgrade the quality and liquidity of the portfolio by modestly trimming our plus allocations and adding to the core sectors, mainly through Treasuries. We've also been adding duration into this rate backup, as we believe rates are getting closer to a peak.
As far as other core sectors, we also like some agency mortgage pass-through securities, or MBS. These securities don't have credit risk, but they do have prepayment risk, and are affected by interest rate volatility which has been sky high this year. In fact, mortgages have been having the worst year since the global financial crisis. Looking forward, we think the risk/reward is looking better. Prepayment risk has dropped significantly because not many people are refinancing their mortgages with rates close to 7%. We think once rate volatility comes down, MBS can perform pretty well. Finally, in the core sectors we are finding value in high quality consumer asset-backed securities and autos and consumer loans. These are short duration securities with good incremental yield versus Treasuries.
What Plus Sectors Do You Find Attractive or Dangerous?
We're not seeing any areas that we think are wildly overextended. But we are avoiding certain segments that we believe are more vulnerable. As an overarching theme, we do not believe you should be sacrificing trading liquidity for yield. There's plenty of yield out there right now. Given the heightened level of volatility, this is when we think you want to have more liquidity in your portfolio, either to meet investors' need for capital or to take advantage of dislocations or opportunities in the marketplace. Finally, we're not big fans of lower quality securitized credit, especially commercial mortgages or non-agency CMBS.
Within the plus sectors, we have trimmed exposure to high yield and high yield bank loans, but we're not running away from this market. Credit fundamentals remain solid. We think this default cycle will be shallower than most, and spreads are pricing in a lot of bad news. We favor the higher quality, BB segment of high yield and certain well-protected bank loan structures.
Given the Strong US Dollar, Is There Any Opportunity in Currencies?
We continue to find value in the non-dollar government bonds of Mexico and Uruguay. These positions, we think, offer good values with yields around 10% to 11%. These two countries have really bucked the strong dollar trend this year. Both the Mexico and Uruguay peso are up versus the dollar year to date, which is in stark contrast to many developed markets' currencies, such as the euro and the Japanese yen, which are down 13% and 23%, respectively. The central banks of Uruguay and Mexico have acted very fast to raise interest rates to ward off inflation. They've tightened even more aggressively than the Fed and, right now, Uruguay and Mexico both have high real policy rates.
Fixed income securities may carry one or more of the following risks: credit, interest rate (as interest rates rise bond prices usually fall), inflation and liquidity.
This material is provided for informational purposes only and should not be construed as investment advice. The analysis and opinion expressed represent the subjective views of Rick Raczkowski as of October 18, 2022 and may change based on market and other conditions. There can be no assurance that developments will transpire as forecasted. Actual results may vary.
Unlike passive investments, there are no indexes that an active investment attempts to track or replicate. Thus, the ability of an active investment to achieve its objectives will depend on the effectiveness of the investment manager.
High yield bond spread, also known as a credit spread, is the difference in the yield on high yield bonds and a benchmark bond measure, such as investment grade or Treasury bonds. High yield bonds offer higher yields due to default risk.
Liquidity refers to the ease with which an asset, or security, can be converted into ready cash without affecting its market price.
Interest rate risk is a major risk to all bondholders. As rates rise, existing bonds that offer a lower rate of return decline in value because newly issued bonds that pay higher rates are more attractive to investors.
Duration risk measures a bond's price sensitivity to interest rate changes. Bond funds and individual bonds with a longer duration (a measure of the expected life of a security) tend to be more sensitive to changes in interest rates, usually making them more volatile than securities with shorter durations.
Below investment grade (high yield) fixed income securities may be subject to greater risks (including the risk of default) than other fixed income securities.
Mortgage-related and asset-backed securities are subject to the risks of the mortgages and assets underlying the securities. Other related risks include prepayment risk, which is the risk that the securities may be prepaid, potentially resulting in the reinvestment of the prepaid amounts into securities with lower yields.
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