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.