The past 12-months will be remembered as one of the worst periods in history for fixed income assets.
This rings true not only in the US, but across all regions as investors have faced the challenge of bonds not providing the ballast that might have been expected.
The rapidly-rising yields, which caused a headache for many fixed income investors this year, were driven primarily by an aggressive US Federal Reserve (Fed) which has been forced to combat the highest inflation in 40 years.
Is fixed income out of the woods yet?
However, we now believe that most of the adverse yield move is behind us as the terminal federal funds rate (the rate at which the Fed is expected to stop raising rates) is currently priced around 5%. This means that after hiking rates by 3.75% this year, markets are only anticipating another 1% in increases through mid-year 2023. This scenario can offer opportunities for long-term investors. As the economy hits the brakes and inflation crests, the opportunity to earn yield is considerable.
The Fed’s actions this year have sought to temper inflation by tightening financial conditions and slowing growth. There are many indications that the economy has started to slow, as higher rates are dampening demand for everything from housing to software. As a result, it is very likely that we will see the US slide into recession within the next 6-to-12 months.
There are also signs that inflation will reach its peak in the short term. However, higher inflation levels are likely to persist as the impact of increasing labour costs, shorter supply chains, and energy transition, will keep core inflation reasonably sticky. As inflation falls from its highs, the Fed will be able to moderate its pace of hikes and interest rate volatility is likely to subside.
Best value in years
The good news is that higher-quality, liquid fixed income now offers the best absolute and relative value it has in many years. Importantly, investors do not need to extend down the credit spectrum or out along the yield curve to earn attractive yields.
Fixed income assets are now more fairly priced than they have been in over a decade, with 2-year Treasuries yielding 4.5% since mid-November and investment grade corporate bonds yielding close to 6%. Meanwhile the S&P 500 dividend yield sits at a paltry 1.7%.
Stabilising inflation and slower growth will be supportive for fixed income assets in the coming quarters.
Four areas of focus
As multi-sector fixed income investors, we look across the fixed income universe for the most compelling opportunities. As such, we have spent much of the last six months building liquidity across strategies, upgrading the quality of our risk across the board, and taking advantage of small pockets of value as they emerge.
With Treasury yields as high as they are, there is less need to extend out across the risk spectrum, particularly as the US economy is likely to enter an economic recession in the coming months. There are four key areas of the market that can offer value: Treasuries, short maturity investment grade corporate bonds, agency mortgage-backed securities, and municipal bonds.
Positioning in these higher quality instruments will allow investors to earn attractive yields while retaining ample liquidity, which can be deployed as new opportunities in riskier sectors emerge.
In at the short end of investment grade credit
While US investment grade corporate spreads are clearly more attractive than they were a year ago, they are not yet at recessionary levels, which necessitates some caution from investors.
As a result, it will serve investors well to remain focused on the least “risky” pocket of the corporate market.
Short maturity investment grade bonds, in particular, now offer yields north of 5% (see chart below). With credit curves flat, there is little need to buy longer maturity corporates with high degrees of spread sensitivity, especially given that it is likely that credit spreads will widen as the US economic outlook deteriorates. Short-dated bonds will, however, be relatively insulated from such moves, given their low sensitivity to price changes and the high degree of income that they generate.
ICE BofA 1-5 Year US Corporate Index Yield: broken down into components
Another area of the market that has become more attractive recently is the securitised sector, particularly agency mortgages. This is a AAA-rated sector with an implicit government guarantee and as such, there is no credit risk, only convexity risk such as the risk of prepayments or extensions. Therefore, the time to buy agency mortgages is when both volatility and spreads are high, as they are today.
Investors in the mortgage market were quite concerned with the notion of the Fed converting from the largest buyer of agency MBS to a net seller, which caused spreads to widen quite aggressively (see chart below). The sector has deeply negative excess returns this year — comparable to the investment grade credit market - a very unusual result given the disparity in ratings. However, it is likely that steadily adding exposure to agency mortgages, preferring the liquidity and spread here as compared to the corporate market, may pay off in the coming months.
Bloomberg US MBS Index: OAS and excess return YTD
Municipal market’s growing appeal
Yet another emerging opportunity lies within the municipal market. Tax-exempt municipal bonds tend to attract tax-paying investors who are more sensitive to total returns. When fixed income produces deeply negative total returns, as it has this year, the sector is sold indiscriminately. After a year of historic inflows in 2021, outflows this year are the worst since the data has been collected (1993), with over $103 billion leaving so far this year (see chart below).
As a result, municipals have undergone a significant re-pricing despite improving fundamentals. It looks like the sector has now cheapened enough to make it attractive even for non-tax-paying investors. Additionally, it has the benefit of less exposure to the economic cycle than other credit sectors.
Another consideration for investors looking for an appealing combination of cheap valuations, high quality and diversification, would be taxable municipal debt. The asset class has suffered this year and now looks attractive relative to long-dated corporates.
Municipal flows (in billions) reversed course in 2022 as rates rose
Tightening cycles usually provoke fractures, sometimes idiosyncratic and sometimes systemic. While central banks and markets can usually manage idiosyncratic risks, there is a concern about how a systemic rupture will be priced by markets and addressed by policy makers.
Managing these risks will be more difficult in an environment where governments do not have access to the traditional policy levers due to already high debt burdens and still-too-high inflation. The recent UK experience is testament to just how sensitive markets are to increasing debt burdens in a period of receding liquidity.
Currently, patience is the name of the game. Valuations have not yet justified a bullish stance across broad credit markets, but it is good to keep some liquidity available for when opportunities present themselves as the tide of liquidity continues to recede.
The good news is that high quality, liquid fixed income now offers attractive yields where investors can sit and wait for even better opportunities to present themselves.