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.