The Fed’s task this time around will be made harder still by its decision to pivot from quantitative easing (by pumping liquidity into the bond market through the purchase of bonds) to quantitative tightening, which is now draining liquidity from the bond market. “We haven’t seen a time when the Fed is both raising rates and shrinking its balance sheet,” says Rob Almeida, a fixed-income portfolio manager at MFS Investments. He thinks the Fed “will effectively quash aggregate demand, including demand for labor.”
Summing up the uncertain path ahead, PIMCO strategists recently wrote that in the next phase of the economic cycle, “the range of possible outcomes [is] particularly wide.” The report’s authors add that “central banks are in a miserable position, having to address inflation while growth is already at risk.”
Not all strategists agree that a sharp reduction in economic activity is inevitable. PIMCO’s strategists suggest that “despite this challenging outlook, our baseline view is for relatively shallow recessions across the major developed markets.”
David Norris, head of credit at TwentyFour Asset Management, thinks the soft-landing scenario “has a higher probability [than a hard landing], given the strength of the consumer.” Thanks to firm employment levels and moderating gasoline prices, the Conference Board’s consumer confidence index bounded higher in each of the last two months of the third quarter.
Even as advisors focus on the best ways to position portfolios with suitable bond funds, they also need to decide whether a passive or actively managed approach makes sense. Passive bond ETFs almost always offer the lowest annual fees, yet active bond fund managers can move more nimbly across the opportunity set. This past September, Morningstar compared 10-year returns for bond ETFs and mutual funds and found that, in the sphere of corporate bonds in particular, active funds delivered an average 75% total return, while bond ETFs offered a 53% total return. (In other bond fund categories, the results are mixed.)
Staying Defensive
The uncertain path ahead has led to a broad consensus among fixed-income fund managers—they must focus on investment-grade bonds (also known as “blue chip” bonds), which are issued by companies with robust cash flow and reasonable levels of debt. “Balance sheets remain quite strong” at such companies, says Norris.
At the present moment, it’s unwise to instead own the debt of financially weaker companies, says MFS’s Almeida, arguing that investors “haven’t yet discounted the possibility of a recession.” That could create profound strain in the high-yield (i.e., “junk”) bond market. If the economy contracts in 2023, “a lot of companies may struggle to earn their cost of capital,” Almeida says.
That’s a surefire recipe for more bond defaults if near-term maturities can’t be rolled over. However, Westwood’s Barnard notes many leveraged corporations were able to refinance and bolster their balance sheets with low-cost debt during the pandemic, pushing the prospect of junk bond defaults further out several years. This doesn’t preclude some credit downgrades next year if companies report disappointing earnings, he adds.
“Each successive rate hike has more pressure and intensity attached to it,” says Permanent Portfolio CEO and chief investment officer Michael Cuggino. “But will a 4.5% fed funds rate get us down to 2.0% inflation? I don’t know if that will get us there.”
Cuggino remains skeptical that the Fed’s 2.0% inflation target is achievable in the next year or two, partly because the central bank might have to inflict too much economic pain to reach that goal. “When push comes to shove, there is a [market] perception that the Fed will cave” to pressures from investors and politicians, he notes.
Schroders’ Sutherland assumes that a recession in 2023 is almost inevitable, calling it his “base case scenario.” His firm’s Hartford Schroders Sustainable Core Bond Fund (HSAEX), reflects that view, as the majority of corporate bonds are investment grade and have shorter maturities. The fund also has a sizable stake (39%) in U.S. Treasurys, and Sutherland notes that with yields on many government bonds now above 4%, “prospective returns are likely to be far more favorable even if yields continue to rise modestly. The opportunity in higher quality fixed income looks as attractive today as it has in over a decade.
Almeida oversees the MFS Diversified Income Fund (DIFIX), which has assets invested in a range of bonds and stocks, though the fund manager notes that “the most attractive opportunity in my view is among mortgage-backed securities and longer-duration government bonds.” At first glance, housing-related bonds may not hold evident appeal.