Fixed-income investments have endured one of the greatest selloffs of the modern era. Long-term Treasury bonds, for example, lost more than 18% this year through April 30, the worst performance since 1842, according to research from Santa Clara University. To be sure, many advisors took cover before the storm clouds circled, shunning exposure to longer-term bonds whenever possible, for example. Yet even seemingly safe investments such as Treasury inflation-protected securities (TIPS) have fallen nearly 10% in value this year.
While the fixed-income seas are still churning for the time being, the outline of an eventual recovery in bond markets is beginning to emerge, and it has implications for advisors seeking opportunities in the intermediate and long-term end of the bond market. Other income-producing investments will also grow in appeal.
Take municipal bonds. For years, they offered dismally low payouts. Now, thanks to the broader bond market backup, munis are getting a fresh look. On a tax-equivalent basis, the iShares National Muni Bond ETF (MUB) now sports a 4.9% yield as of May, according to the firm’s website. Closed-end muni bonds offer even higher yields, since they are selling at sharp discounts to net asset value.
Lisa Hornby, the head of U.S. multi-sector fixed income at Schroders, says “munis are a high-quality market with strong fundamentals,” thanks to strong property and sales tax receipts, and recent generous stimulus funding from Washington.
Before examining other opportunities, it’s important to understand how the current bond turmoil will come to an end.
Converging Toward Neutral
While the Federal Reserve Open Market Committee is on pace to raise interest rates at meetings in June, July and September, the path after that is less clear. The Fed wants to reach a “neutral rate,” for stable inflation. Trouble is, few agree on what that rate is. Fed chair Jerome Powell concedes that it’s an amorphous target.
David Norris, head of U.S. credit at TwentyFour Asset management, says that at a minimum the neutral rate would be 2.5%, but also says it could be as high as 3.0% to 3.25%. He thinks the Fed “will err on the side of being dovish,” perhaps focusing on the lower end of those figures.
He also thinks we’ll see rate hikes end on the earlier side as the Fed aims to pull off a “soft landing.” That’s typically defined as an interest-rate induced slowdown that still leaves an economic expansion intact.
Others aren’t so sanguine. Dartmouth professor Andrew Levin, who has served as a special advisor on monetary policy strategy to the Fed in past years, thinks the neutral rate will be closer to 5.0% or 6.0%, a scenario that portends lots of further pain to come in the bond market as rate hikes continue until yields and prices stabilize.
Erik Weisman, the chief economist at MFS, splits the difference. “If we get inflation down to 4.0%, then the Fed will pause its hikes,” he says. Still, he remains doubtful the central bank will get its soft landing. “Everything would have to line up perfectly for that kind of outcome,” suggesting inflation would need to fall to that 4% level by this summer, not later in the fall or winter.
“You have to hope that it doesn’t take 18 months for inflation to cool, because if not, the Fed would need to keep raising rates into 2023,” he adds. Weisman is concerned that the current global supply chain woes may keep inflation at elevated levels, though a reduction in supply-chain bottlenecks would make it easier to pull off a soft landing.
Neel Kashkari, president of the Minneapolis Fed, recently wrote that if supply constraints “don’t unwind quickly … then we will likely have to push long-term real rates to a contractionary stance to bring supply and demand into balance.” He added that several months of data should make it clear whether the Fed will have to tighten further.
Lindsay Rosner, a portfolio manager and principal on the Multi-Sector Portfolio Management Team at PGIM Fixed Income, doesn’t think that the Federal Open Market Committee’s voting members are likely to take such a hawkish stance. “It is going to be hard to avoid a hard landing (which usually leads to a recession), so the Fed will likely raise rates less than is currently priced in,” she says. While both equity and fixed-income investors pin their hopes on a moderate slowdown, Schroder’s Hornby notes that whenever the Fed has raised rates to slow the economy over the past century, it has engineered a soft landing just 10% of the time.
The good news: Inflationary pressures are beginning to recede. As measured by the 10-year breakeven rate, inflation expectations fell from 2.98% in April to 2.86% in May. It might be an oversimplification of things, but if inflation continues to fall from its 19-year peak, the Fed may be able to stop short of a more extended phase of rate hikes. (MFS’s Weisman says to watch month-to-month inflation readings, which aren’t subject to distorting “base effects” that occur from statistical lows.) Fewer than expected rate hikes would likely signal fresh bullishness for both stock and bond markets. Ahead of that perhaps ideal outcome, this is a good time to develop a fixed-income road map for opportunities that are emerging in the near and intermediate term.
To be clear, the economy is unlikely to see a growth spurt at the end of the rate hike cycle, as an economic slowdown is already underway. This means investors should be focusing on “late cycle” plays, according to Norris—including credit quality with high-quality bonds—and shunning lesser quality high-yield bonds. “Only when we reach a peak in rates and Fed policy is neutral to restrictive should investors be considering high-yield bonds,” says Norris. That’s typically a time when junk bonds have sold off and offer yields justifying the risk in a period of economic adversity.
Weisman continues to look for fixed-income opportunities, though he currently focuses on “where I am going to get dinged the least,” adding that he is focused on shorter duration bonds for now. However, he is keeping an eye on countries where “central banks are further along the tightening phase.” Countries like England, Mexico, Chile and Brazil began raising rates last year and may be closer to the end of their rate hike cycles. As the various central banks announce plans to wind up interest rate hikes, that may open the door for emerging market intermediate and longer-term bonds. The yield on the iShares J.P. Morgan USD Emerging Markets Bond ETF (EMB), for example, now approaches 6%.
For now, Schroders’s Hornby remains squarely focused on shorter-term bonds, noting that yields have become “very compelling among” investment-grade bonds with two to three years of duration. “You can hide out on the front end of the curve while waiting for inflation to moderate,” she adds.
PGIM’s Rosner takes a more balanced view. “The negative returns in bonds from expected coming hikes have largely been priced in,” she says, adding that the “duration headwinds may soon be behind us.” That view suggests that interest rates on longer-term bonds may not rise much further, especially if the U.S. economy continues to slow.
Lance Roberts, chief investment officer at RIA Advisors, says that an incipient economic slowdown has already taken root. “Retail sales are softer than many people realize. Credit card debt has surged as many people are wrestling with wage declines in inflation-adjusted terms,” he says. He figures that “recession may be inevitable, but that’s not necessarily a bad thing. … It is a kind of forest fire that clears out the undergrowth so new growth can emerge.”
While advisors navigate the impact of interest rate hikes, inflation and economic growth rates, there is one more key factor to monitor: quantitative tightening (QT). Recall that the Fed aimed to goose growth through massive bond purchases known as quantitative easing (QE). QT has the opposite effect, applying the brakes to an economy that is already slowing down. “The process has been well-telegraphed by the Fed,” says Hornby, “but there is no consensus of the outcome of QT.” By later this summer, the central bank will be shrinking its balance sheet by around $95 billion per month. Bank of America predicts the Fed will own $3 trillion less in bonds three years from now.
With so many challenges in place, we can’t rule out the possibility of more dire bond market stresses, as we saw in 2008. “If we have a ‘credit event’ like that, I want to be in U.S. Treasurys,” says Roberts. “In 2008, everything else was trashed, but Treasurys rallied. That’s where people will go if we have a major risk-off event.”
The era of “easy money” is surely behind us. As yields rise, though, advisors can start to make a much stronger case for the role of income-producing investments in portfolios that may have been too stock-heavy in recent years. Amid the inflation trends, when core prices are no longer rising sequentially, intermediate and long-term bonds may be poised to rate back into favor.