Market Views: Fixed Income
Outlook 2018: US multi-sector fixed income
Bond yields hit their year-to-date lows in early September, with the 10-year Treasury yield getting as low as 2.03% before trending back up towards 2.40%. Low yields in the Treasury market are accompanied with historically expensive corporate and municipal bonds.
Investors faced with an expensive bond market now have to incorporate tax reform uncertainty and the impact of the Federal Reserve unwinding quantitative easing (QE) and shrinking its $4.5 trillion balance sheet into their decision making. So how can you approach your bond portfolio in this environment? We believe you will need three attributes – realism, patience and flexibility.
The reality check
With the market environment described above it is perhaps unwise to expect your bond manager to be the driver of a double digit or even high-single digit return on your portfolio. Those historical returns are likely a thing of the past.
Outside of liability-driven investors, we believe the role of your fixed income allocation in times like these should be to provide principal stability and some income so that you can face future market volatility from a position of strength. That isn’t to say you shouldn’t expect your bond managers to be working hard to make the best of the opportunities out there but with this as a starting point there is a limit to what we can do.
Lessons of the past
The lessons we have learned from the previous cycles are that over the short-term valuations tend to be driven by supply/demand and fear/greed. Risk appetite and sentiment may dominate for a time but over the long-run fundamentals will always drive valuations.
The key is to focus on the tangibles, the most obvious of which is value or the price you pay for a bond. The price is likely to have a big influence on future returns. Credit analysis will define the likelihood of the issuer paying coupon and principal and the market will decide how quickly that probability is reflected in the price.
We don’t believe that there is a big role for forecasting, the task at hand is to buy cheap bonds that have good fundamentals. If the bonds are cheap because of weak fundamentals, make sure you are being compensated for the risk.
Patience needed today
Applying this framework to today’s market is challenging. Very few fixed income assets are cheap, even if they should be, and investors’ appetite for yield continues to drive liquidity premiums lower.
Patience is an important attribute as we wait for better opportunities to take risk. Investors pay close attention to yields as a proxy for total return but in our experience bond market returns tend to be more episodic and are rarely delivered in a uniform fashion month after month.
Tax-exempt municipal bonds
Focusing on the tax-exempt municipal bond world, what signals are we paying attention to? We have found that headlines rarely drive broad municipal market moves. For instance, Puerto Rico’s fiscal distress was pretty well telegraphed and thus the broad municipal bond market barely budged when they defaulted on their debt or now as their bonds fall further.
People often believe that lower marginal tax rates drive demand for municipal bonds. While marginal tax rates are an important input into relative value measures, our research has shown that the impact on retail investor appetite for tax-exempt municipal debt is minimal at best. 35% tax rates were the norm from 2003 to 2012. A lower marginal tax-rate as proposed by President Trump is unlikely to have a meaningful impact on retail demand.
In fact, even as the municipal market transitions from an interest rate to a credit-driven market, we have found that the most significant driver of muni demand is still the direction of rates. When retail investors experience or anticipate a significant rise in rates we tend to see persistent mutual fund outflows. These periods often offer the opportunity to buy attractively priced bonds with solid fundamentals when everyone else is selling.
Taken to the other extreme, what is an investor to do when the markets are expensive? Here is where flexibility comes into play. At the fund level – take less aggregate risk in the expensive sectors and focus on after-tax total return. Sometimes it pays to own corporate bonds and pay your taxes, leaving more money in your pocket. This is exactly how banks and insurance companies invest their own portfolios – maximising after-tax total return. Focus closely on the impact on the portfolio of a sharp decline in the bond market, we call that break-even analysis. How much income does the portfolio provide and how much cushion will that provide in the event that prices fall?
So how should you approach the market today? Keep your credit risk contained, your interest rate risk moderate and most importantly, your powder dry.
 Liability-driven investors are those whose investment strategy is based on the cashflows to fund future liabilities.
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