From the early days of Ronald Reagan’s first term in the White House, the bond market was in rally mode with only a few brief interruptions, as falling yields led to rising fixed-income prices. While a reversal of fortune was likely inevitable, few knew at the start of 2022 that the 30-year rally would come to such a violent end.
“The fixed-income returns we’ve seen this past year are close to the worst on record,” says Neil Sutherland, a portfolio manager at Schroders. The silver lining: Bond prices have moved lower and yields are up. “That suggests we’re looking at better values than we’ve seen in quite some time,” he adds.
That’s not to say that fixed-income investors should expect smooth sailing ahead. While we’ll likely see inflation fall from recent peaks, it will be a while before we know how quickly price pressures will cool, and equally important, by how much.
If inflation does trend lower and moves back below 5% this winter, then the Federal Reserve may not need to raise interest rates as high as some have feared. That could help pave the way for a proverbial “soft landing” for the U.S. economy.
What would constitute a soft landing? Unemployment rates, which currently sit below 4.0%, would rise toward the 4.5% to 5.0% range, but no higher, and that rate could sustain current levels of consumer spending. And in such a soft landing/modest recession scenario, companies would be more likely to maintain ongoing capital spending plans while keeping layoffs to a minimum.
Yet inflation has remained stubbornly persistent, notes Scott Barnard, a portfolio manager at Westwood. If metrics like the Consumer Price Index fail to show a steady decline, the Fed may need to raise interest rates for a longer stretch, perhaps to the point where economic activity contracts into a deep recession.
The rapid rise in global interest rates already is roiling markets as diverse as housing, autos and pensions. In these circumstances, the likelihood that “something will break” increases significantly, Barnard says. “Look at the U.K.”
Last month, the Bank of England was forced to inject liquidity into the bond market after U.K. pension funds deploying so-called liability-driven investing strategies were hit with margins calls. In addition to those challenges, Sutherland adds that the “surging dollar may also bring unintended consequences to the bond market.”
If the economy and markets continue to weaken, investors will also need to consider the “misery index,” which combines the inflation rate and the unemployment rate. Bond management firm PIMCO noted in a recent year-ahead outlook that a rising misery index would portend “a stagflationary shock that will probably hinder the U.S. economy at a time when it is also dealing with some of the fastest tightening in financial conditions since the 2008 financial crisis, generally low consumer and business sentiment, and elevated uncertainty.” All this raises “the risk of a harder landing for the U.S. economy.”
Sutherland thinks it will be pretty difficult for the Fed to engineer a “soft landing.” If a serious recession unfolds, Barnard believes that longer-term bonds would rally significantly as growth and inflation expectations start to diminish.
Missing the mark on inflation isn’t the only reason that the Fed’s credibility is suspect. At the start of 2022, the central bank predicted real GDP in the U.S. would come in at about 4.0%. Now that figure looks likely to be closer to 1.0%, Barnard says.
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.
After all, mortgage-backed securities were the source of epic levels of distress in the last economic downturn as collateralized debt obligations (CDOs) and underwater mortgages combined to produce large-scale losses for bond investors. The mortgage industry has cleaned up its act since then as lending standards have become much tighter. “Leverage in the housing market has been greatly reduced as well,” notes Sutherland. “Mortgage lending has been a lot more responsible.”
Mortgage-backed bonds are surely more appealing to income-oriented clients now than they were a year ago. In the summer of 2021, the Bloomberg U.S. MBS Index sported a yield of 1%. In the fourth quarter of 2022, the average yield to maturity stood above 4.5%. The iShares MBS ETF (MBB) is the largest in the category, with around $20 billion in assets. PIMCO’s annual outlook reflects an upbeat view as well: “Agency MBS are triple-A-rated assets and offer relatively attractive spreads, high levels of resiliency and good liquidity.”
Munis Could Be A Bright Spot
Through much of 2022, many advisors have been moving to cash while they make heads or tails of the uncertain economic outlook. Karen Veraa, head of fixed-income strategy at iShares, notes that $300 billion has flowed out of bond mutual funds this year while only $100 billion has flowed into bond ETFs through the first three quarters of 2022, suggesting $200 billion remains sidelined. A peek into fund flows across the iShares bond fund spectrum suggests that investors are embracing municipal bonds. (The iShares National Muni Bond ETF, whose ticker is “MUB,” has seen $5 billion in net flows year to date.)
John Miller, head of municipal bonds at Nuveen, notes a clear disconnect in the muni bond market. “The fundamentals [of state and local municipal finances] are strong while market volatility has hit the bonds hard,” he says. Thanks to a range of factors, including heavy transfers from Washington that came with the American Recovery and Reinvestment Act of 2009, robust property tax revenues and restrained spending, Miller says that cities and states are sitting on record levels of cash reserves. Moreover, “if you’re expecting a recession, municipal finances tend to be very resilient,” he adds.
Miller believes that longer-term munis are especially attractive at the moment, and his firm’s Nuveen All-American Municipal Bond Fund (FLAAX) reflects that, carrying an average bond maturity of around 20 years. Miller concedes that the sudden rise in benchmark interest rates have led advisors and their clients to lighten exposure to munis in general, noting that the asset class has been hit with $105 billion in outflows through the first nine months of 2022.
Yet he suspects that “2023 could be a much better environment for munis, thanks to their compelling after-tax yields.” To determine that yield, advisors would take the current 4.3% yield and divide it by one minus the client’s federal tax bracket. The yields on offer for closed-end muni bond funds are even more appealing, as that group has been hit even harder in the bond selloff, thanks to the debt leverage that such funds use. The Nuveen Municipal High Income Opportunity Fund (NMZ) recently offered a 6.3% yield, which is even higher when after-tax yields are calculated.
Going Long
According to the iShares fund flow data, investors have also come to view “duration” in a new light. Recall that in the past few years, ahead of the Fed’s expecting tightening cycle, advisors and their clients fled from longer-term bond funds to reduce exposure to interest rate risk. That was, in hindsight, a very wise move, as the ICE U.S. Treasury 20+ Year Bond Index, which stood at 157 in August 2020, eventually moved below 100.
Nowadays, owning longer-term bonds could be seen as a hedge against a profound economic slowdown. As PIMCO strategists note, “yields are high enough to provide the potential for capital gains in the event of weaker-than-expected growth and inflation outcomes or in the event of more pronounced equity market weakness.”
Long-term inflation expectations, as measured by 10-year TIPS, remain muted and have actually declined in 2022. Westwood’s Barnard notes the yield on these securities fell from 2.59% in January to 2.31% in mid-October. A laddered portfolio of corporate bonds is now a reasonable strategy in his view.
If fund flows are any gauge, investors are now betting that duration exposure will prove to be beneficial in the quarters ahead. Through the first three quarters of 2022, more than $11 billion has flowed back into the iShares 20+ Year Treasury Bond ETF (TLT). More than half of those net inflows came in the third quarter alone, according to iShares’ Veraa. MFS’s Almeida is also a fan of “high-quality, long-duration” bonds, as he thinks the (currently inverted) yield curve will remain in place. The fact that two-year Treasurys offer a higher yield than their 10-year counterparts suggests that recessionary conditions lie ahead.
Credit-Like Equities
While investors scour the bond market for yields, they should also take note of the backup in yields available in equity markets as well. For example, the stock market pullback in 2022 has pushed up yields on preferred stocks. The iShares Preferred and Income Securities ETF (PFF) currently yields around 5.6%. Investors may recall that preferreds came under strain in 2008 as banking industry finances deteriorated. Banks are the dominant issuer of preferred stocks. Veraa suggests that banks are now in much stronger shape, and in response, “preferred stocks would hold up very well in a soft-landing scenario.”
While bond markets have caused deep headaches for advisors and their clients, the road ahead should prove to be much more fruitful for fixed-income investors.
David Sterman is a journalist and registered investment advisor. He runs Huguenot Financial Planning, a New Paltz, N.Y.-based fee-only financial planning firm.