FORESIGHTLong read

Headwinds and tailwinds abound in fixed income markets

The macroeconomic environment in the second quarter was characterized by the resolution of certain concerns, such as the debt ceiling, and the anticipation of a recession and persistent inflation. With a careful assessment of risks and opportunities, relative value fixed income investing may offer attractive returns and portfolio stability in an ever-changing market backdrop.

27/07/2023
Recession_recovery

Authors

US Multi-Sector Fixed Income team

Macro milieu 

In the second quarter, the macroeconomic environment presented several interesting developments and challenges. The resolution of the debt ceiling issue and the transition from LIBOR to SOFR had threatened to shake up the markets but ultimately their impacts were far from cataclysmic. Similar to the era of Y2K and the considerable concerns it raised, other periods of fear and speculation often create opportunities for value investors. While the issues we named have resolved, a source of persistent anxiety for investors is the anticipated recession and durably higher inflation. The Fed’s aggressive rate hikes, totaling 500 basis points since the beginning of 2022, have noticeably thwarted inflation, as the Fed’s latest inflation gauge called supercore, which measures the prices of services excluding housing (Figure 1), demonstrates; it has been in decline since peaking above 6% at the end of last year.   

Figure 1: Supercore – CPI core services minus housing (YOY)

Chart 1 CPI core services minus housing (YOY)

Source: Bloomberg. Economic indicators may not be accurate measures of market activity and should not be relied upon to predict future results. 

In June the Federal Open Market Committee (FOMC) paused its rate hiking cycle for the first time since early 2022 but its tone remained somewhat hawkish, with two more hikes planned for the year according to the Fed’s Dot Plot (Figure 2). As of June 30, the Fed funds futures market was pricing in an 81% probability of a hike at the July 26 meeting and the odds of this happening increased early in the third quarter. 

Figure 2: Implied number of rate hikes/cuts and implied Fed funds futures rate as of June 30, 2023

Meeting

#Hikes/Cuts

Implied Rate

7/26/2023

0.811

5.28%

9/20/2023

1.051

5.34%

11/01/2023

1.34

5.41%

12/13/2023

1.207

5.38%

1/31/2024

0.861

5.29%

3/20/2024

0.381

5.17%

5/01/2024

-0.177

5.03%

6/12/2024

-0.885

4.85%

7/31/2024

-1.649

4.66%

9/18/2024

-2.482

4.45%

11/07/2027

-3.246

4.26%

12/18/2024

-3.861

4.11%

1/29/2025

-4.359

3.99%

Fed’s Dot Plot: projections for the Fed funds rate as of June 14, 2023 FOMC meeting (RHS) 

Chart 2 Fed’s Dot Plot projections for the Fed funds rate as of June 14, 2023 FOMC meeting (RHS)

Source: Bloomberg. Forecast may not be realized. 

Despite higher Fed funds rates and escalating mortgage rates, the housing market remained strong and continued to contribute to the broader economy. The availability of homes for sale, measured by "months of inventory," stood at 2.6 months (Figure 3), which falls below pre-pandemic levels and suggests healthy home price appreciation as the supply remains limited. Although mortgage rates were high—above 7%—housing prices remained relatively stable. We attribute this stability to the large portion of outstanding mortgages with interest rates of 4% or lower, along with the majority of primary mortgages being fixed rate. Homeowners with low fixed housing costs were less likely to move and had more discretionary income while potential first-time homebuyers were pushed into renting due to unaffordability. The shortage of affordable housing continues to be a growing problem, leading to a divide between those who own homes and those who do not. The disconnect between housing prices and the CPI’s Owners’ Equivalent Rent will be a key metric to follow in coming quarters as the Fed attempts to squash inflation with the mantra “higher for longer.” 

Figure 3: Housing months of inventory

Chart 3 Housing months of inventory.png

Source: Bloomberg. Economic indicators may not be accurate measures of market activity and should not be relied upon to predict future results. 

One key factor affecting consumers is the impending demise of the reprieve on student loan payments as the Supreme Court rejected President Biden's student debt relief plan as unconstitutional. The resumption of student loan payments would weaken household spending power and reduce inflation. Analysts anticipated a 0.2% drag on headline CPI over the next 12 months, with funds for repayments coming from reduced consumer spending rather than savings.1 This would result in a slight decrease in overall GDP by about 0.1%. The younger cohort who are early in their careers will feel the sting the most because they have a higher propensity to spend (Figure 4). 

Figure 4: Student loans debt by age cohort 

Chart 4 Student loans debt by age cohort.png

Source: Federal Reserve Bank of New York.  

Higher short-term rates resulting from the rate hikes had a significant effect on portfolio construction across the platform. Across our strategies we have employed barbell structures that allocate investments to both short- and long-term securities to meet the desired duration as the yield curve remained significantly inverted during the quarter. This allows us to take advantage of differently shaped curves in the Treasury, credit and municipal bond markets. In addition, short-term bonds provide ample income and allow us flexibility to invest in high-quality corporates and Treasuries further along the yield curve while waiting for wider credit spreads to materialize. 

Corporate bonds compensate for competing forces  

The corporate bond market experienced notable trends and developments during the quarter. The overall economic environment showed signs of slowing down, accompanied by headwinds such as higher funding costs for banks and reduced discretionary spending for consumers. These factors contributed to the weakening of corporate fundamentals as companies faced a slower economic growth environment and higher costs. 

When analyzing Q1 metrics, it becomes evident to us that revenue and EBITDA trends have weakened in line with the softer economic backdrop. Year-over-year EBITDA growth remained flat as of Q1 and EBITDA margins also showed signs of weakening. The combination of slow economic growth and stickier inflation on the cost side resulted in weaker credit metrics. Although leverage was modestly increasing, with interest coverage declining due to higher rates, there were no signs of liquidity issues among companies. Interestingly, many companies have been making adjustments in preparation for the anticipated recession. These adjustments include reducing debt issuance and curtailing stockholder-friendly activities like dividend payouts and stock buybacks. 

During the second quarter, spreads for the  Bloomberg US Corporate Index tightened materially from their wides in mid-March, decreasing from 163 bps to 123 bps. This reflected the market's shift from concerns surrounding the debt ceiling and regional banks to the more mundane dynamics of supply and demand. Despite economists' predictions of a 65% probability of a recession as of June 30, the highly anticipated downturn continues to elude us.2 It is worth noting that the current spreads imply a GDP growth rate of ~2%, significantly higher than the 1.3% forecast from the Bloomberg survey of economists. The perception of a recession, however, may differ among recently laid-off Wall Street bankers, Silicon Valley tech professionals or Credit Suisse employees. 

Despite tighter spreads and moderately weaker fundamentals, the persistent search for yield in the fixed income markets remained at the forefront of investors' minds. The yield on investment-grade  corporate bonds has only been higher than it is today 3% of the time over the past decade, highlighting the allure of yields in supporting increased demand from institutional investors. Given the increase in short-term rates, it is important to consider foreign demand for US dollar credit, as it has been a significant factor in supporting the markets over the last several years. The higher Fed funds rate has raised the cost of hedging for foreign investors. While foreign demand for dollar-denominated securities persists, it has diminished due to increased hedging costs, which are currently 5.7% for the Japanese yen (JPY) and 4.3% for the Taiwanese dollar (TWD). These levels represent decade-highs. On the other hand, domestic demand from pension funds and insurance companies has grown, driven by de-risking strategies into fixed income assets. The 100 largest pension plans, with a funded status of 101%, have contributed to this increased domestic demand. 

Expensive corporate bonds have been a source of liquidity for well-priced agency MBS bonds, which has led us to reduce corporate exposure as spreads tightened during the quarter. We capitalized on the strong demand for the sector, primarily by selling some Yankee bonds, as they were a top performer. We used the proceeds to add to our agency MBS position while repositioning into higher quality corporates to take advantage of their attractive yields. 

Looking ahead, the corporate bond market will continue to be influenced by a combination of economic factors and investor behavior. Any further growth slowdown or recessionary indicators could impact corporate fundamentals and credit metrics. Additionally, the search for yield is likely to motivate investors, keeping demand for corporate bonds strong, especially among institutional investors. The interplay between foreign and domestic demand will depend on factors such as hedging costs, which may continue to impact foreign investors' appetite for US dollar-denominated securities. It will be crucial for market participants to monitor economic trends, central bank policies and geopolitical developments as they navigate the corporate bond landscape in the coming quarters. 

Agency MBS boast yields and performance 

Agency MBS demonstrated their appeal in terms of yield relative to corporate bonds during the quarter. When corporate yields drifted lower, investors sold those bonds and bought higher yielding agency MBS. Specifically, 30-year current coupon agency MBS yields were at 5.52% at 166 basis points of zero volatility spread. It is noteworthy that despite the expectation of widening spreads due to the sale of billions of dollars of mortgages from Silicon Valley Bank and Signature Bank portfolios, Q2 market movements were quite the opposite. Surprisingly, the most pronounced outperformers in Q2 were the low 2% coupon bonds, primarily owned by the Fed. These bonds outperformed Treasuries by an impressive 115 bps.  

Looking ahead, agency MBS will continue to be an attractive option for investors seeking yield and stability. Their ability to provide a ceiling for corporate yields and their strong performance relative to Treasuries make them an attractive investment choice. However, market participants will closely monitor the unwinding of the Fed's agency MBS bonds, as it may impact market dynamics and investor sentiment. Overall, agency MBS are expected to remain a significant component of portfolios as they offer compelling yields, ample liquidity and provide a high quality ballast to portfolios. They are also relatively cheap and offer a strategic investment opportunity as the market navigates the unwinding of the Fed’s remaining $2.5 trillion in agency MBS bonds. 

Figure 5: Intermediate corporate spreads vs MBS spreads 

Chart 5 Intermediate corporate spreads vs MBS spreads.png

Source: Bloomberg and ICE BofA. Shown for illustrative purposes only and should not be interpreted as a recommendation to buy or sell. Current performance trends provide no guarantee of future results. 

High yield prevails over its own problems 

In the second quarter of 2023, HY bonds emerged as the star performer, surpassing IG bonds in terms of excess returns. With year-to-date excess returns of 411 bps and 279 bps in Q2, compared to 156 bps YTD and 131 bps in Q2 for IG bonds, HY bonds proved their resilience. HY companies adopted a conservative balance sheet approach, similar to IG companies, by avoiding more debt and reducing capital expenditures. Despite low spreads, there was tension between yield and spread, with yields remaining in the 8%-9% range during the quarter while spread fell from a high during the quarter of 489 bps to 390 bps on June 30 (Figure 6).  

Figure 6: Bloomberg US High Yield index: Yield to worst and Option-Adjusted Spread (OAS) 

Chart 6 Bloomberg US High Yield index Yield to worst and Option-Adjusted Spread (OAS).png

Source: Bloomberg. Shown for illustrative purposes only and should not be interpreted as a recommendation to buy or sell. Current performance trends provide no guarantee of future results. 

Interestingly, in Q2 there was selective compression as CCC-rated bonds outperformed BB-rated bonds by 2.5 times. The richness of the HY market is evident in the fact that our dedicated HY team has been gravitating towards BBB-securities, with the spread between BB and BBB reaching post-Covid lows at 100 bps (Figure 7). 

Figure 7: Spread (in bps) between BB-rated and BBB-rated corporate securities

Chart 7 Spread between BB-rated and BBB-rated corporate securities.png

Source: Bloomberg. Shown for illustrative purposes only and should not be interpreted as a recommendation to buy or sell.  Current performance trends provide no guarantee of future results. 

Modestly rising defaults and a long maturity runway indicate stability in the market. Rising stars also provided a stabilizing effect. However, highly leveraged issuers face tighter financial conditions and input costs pose a headwind for both HY and IG issuers. Overall these factors suggest that tighter financial conditions will remain a concern for highly leveraged issuers in the near future. A simple regression of high yield spreads suggests an implied GDP rate that is inconsistent with our expectation for growth. Even in a soft landing scenario, we believe the upside in spreads is limited, with significant downside in a weaker growth backdrop. Our view at this time is that the risk reward in high yield debt is not compelling. As such, with spreads at their lowest levels since April 2022, we do not believe that valuations are attractive and we have the lowest level of high yield in accounts that permit HY investments since prior to the pandemic. 

Emerging markets harness the tide 

Despite a challenging macro backdrop and weaker commodity prices, EM bonds registered positive total returns in the second quarter. Indeed, the global economy is exhibiting remarkable resilience thanks to strong services activity. Inflation dynamics in EM countries are beginning to look more benign than in developed markets at this stage. Most EM countries have a CPI basket with a higher share of food and energy and thus they have not had to face the same challenge from rising services prices. Inflation dynamics have also been supported by proactive EM central banks that generally started their hiking cycles much earlier than the Fed. The dollar was relatively stable, rising just 0.8%, as measured by the Bloomberg Dollar Spot Index (DXY), while commodity prices were lower 2.6%, as measured by the Bloomberg Commodity Index. Hard currency sovereigns (JP Morgan EMBI-GD Index) rose 2.2% in the second quarter, while corporates (JP Morgan CEMBI-BD Index) performed slightly worse returning 1.4%. 

After a brief stabilization last quarter, measures of global financial liquidity have resumed their severe contraction. However, the stock of (unused) liquidity remains significant, which could continue to provide a cushion for the global economy and for risk assets. In this regard, a number of EM countries appear to be particularly well equipped to withstand the challenging global liquidity backdrop thanks to manageable external financing needs, attractive asset price valuations and very low ownership of the asset class, which makes it less vulnerable to a possible liquidity driven sudden stop. 

Muni opportunities 

In the second quarter municipal bonds also grappled with remarkable dynamics. Fundamentally, municipal issuers continued to benefit from the excess cash reserves they had built up from the federal Covid stimulus funds. Rainy day funds, which act as a buffer during economic downturns, were at a robust 13.2% of general funds spending, well above the pre-Covid historical range of 4% to 9% Figure 8). This strong financial position and credit stability among municipal issuers played a significant role in their relative valuations. 

Figure 8: Rainy day fund balances as a percentage of general fund expenditures by fiscal year 

Chart 8 Rainy day fund balances as a percentage of general fund expenditures by fiscal year

Source: National association of state budge officers. Forecast may not be realized. 

In addition to showing credit stability, tax-exempt municipal bonds performed well despite the sale of FDIC lists from the Silicon Valley Bank and Signature portfolios in the secondary market, mirroring the trend seen in agency MBS. However, the primary driver behind the movement in valuations of tax-exempt municipal bonds was the fear of sticky inflation and the Fed’s commitment to keeping rates "higher for longer." This concern has led to $8.1 billion in outflows year to date from the municipal bond market. 

Despite the risk of modestly higher interest rates, we feel we are adequately compensated for this potential move. We find value in low-coupon (3%-4%), long-duration, high-quality tax-exempt bonds that offer yields well above 4%. These high-quality, long-duration tax-exempt municipals can function as a great hedge against either a recession or the Fed’s successful battle against inflation. Shorter maturity municipals are extraordinarily expensive and have been a source of funding for agency MBS in some cases. Comparable duration Treasuries and high-quality corporates offer an after-tax advantage, so we have favored them in recent months. 

Looking ahead, municipal bonds will likely continue to respond to factors such as the economic environment, inflation expectations and Fed policies. The availability of excess cash reserves among municipal issuers should provide some stability and support for their creditworthiness. However, investors will closely monitor the Fed‘s stance on interest rates and its strategies to combat inflation. The potential for higher interest rates could impact the performance of long-duration municipal bonds, although their high quality and potential as a hedge against economic downturns may continue to attract investors seeking yield and stability.  

Conclusion 

The macroeconomic environment in the second quarter was characterized by the resolution of certain concerns, such as the debt ceiling, and the anticipation of a recession and persistent inflation. The housing market remained robust despite higher mortgage rates, while higher short-term rates influenced portfolio construction. The end of the reprieve on student loan payments will likely pose challenges for consumer spending and inflation. Overall, these factors contributed to a complex economic landscape with both opportunities and potential headwinds. 

The quarter presented a dynamic fixed income landscape with opportunities and challenges across different sectors. Despite these macroeconomic concerns, value investment opportunities emerged. Agency MBS offered compelling yields and acted as a ceiling for corporate yields, while high yield bonds outperformed investment-grade bonds and demonstrated resilience. Municipal bonds benefited from the excess cash reserves of issuers and remained attractive as a hedge against a potential recession or inflation battle. It is important for investors to consider the evolving macroeconomic conditions, central bank policies and market dynamics as they navigate the fixed income market in the coming quarters. With a careful assessment of risks and opportunities, relative value fixed income investing may offer attractive returns and portfolio stability in an ever-changing market environment. 

1JP Morgan. 

2Bloomberg. 

Authors

US Multi-Sector Fixed Income team

Topics

Fixed Income
Market views
Economics
Economic views
US

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