Volatility drives opportunity in fixed income
Volatility drives opportunity in fixed income
Value thrives amid volatility
While many of us expected turbulence in 2022 in anticipation of Federal Reserve (Fed) rate hikes, none of us envisioned tremendous volatility across the fixed income universe in the first quarter. The Fed was front and center in our calculations, as was inflation, but the invasion of Ukraine was unexpected and injected another level of uncertainty into markets that were already precarious. Of course, our thoughts and prayers are with the people of Ukraine. We wish we could say that war is unprecedented but unfortunately these events happen. It was just two years ago when we wrote our commentary as we faced a different crisis, the start of the Covid pandemic. There was no script to follow back then and nor is there one now.
As we navigate the uncertainty that has weighed heavily on the markets, rest assured that the resulting volatility is exactly the environment in which our value approach thrives. We think back to our old mantra: supply, demand, fear and greed dynamics as drivers of market valuations. At this stage fixed income markets are receding from their fear mode and we are well positioned to capitalize on a move in either direction.
The absolute opportunity in fixed income surges
Absolute returns for fixed income in the first quarter have been the most negative in almost 40 years. Five-year Treasuries have moved from a yield just over 0.5% last summer to almost 3% at the time of writing. While no one likes to see negative absolute returns, the positive interpretation is that the opportunity and yields available to investors are now more attractive than they have been at any point during the last ten years, with the exception of the Fed hiking cycle of 2018. With inflation peaking and a very aggressive path of Fed hikes already discounted into markets, we believe that forward returns for fixed income are likely to be much more favorable. If markets remain stable or yields drop, investors stand to earn greater returns than have been available during most of the last decade. In addition, there is now a significant margin for error – or cushion – should another adverse move in rates/credit spreads occur.
We started off the quarter with historically tight corporate spreads of 92 basis points (bps) and only three Fed rate hikes priced into the Treasury market through early 2023. The fundamental backdrop was as positive as we had seen in quite some time, with GDP consensus forecasts at a healthy 4% for all of 2022, Core PCE forecasts at a manageable level of 3.3% for 2022, corporate earnings for Q421 expected to be approximately +20% YOY and corporate leverage trending lower. The economy was relishing the tailwind of the trillions of dollars of both fiscal and monetary stimulus received over the preceding couple of years.
Yet despite these expectations, the absolute return of the Bloomberg Aggregate Index for the first quarter of 2022 was -5.9%, the third worst quarter since the inception of the index in 1976 as rates on the 2-year Treasury rose 160 bps and on the 10-year Treasury 83 bps. The absolute return at the end of this past quarter was only surpassed by the first (-8.7%) and third (-6.6%) quarters of 1980, when Core PCE was running at 8.8% and 9.2% respectively, almost double the 4Q21 level of 5.0%. Our intent is not to scare you but to point out that the subsequent quarters experienced absolute returns that were positive: +19.8% in Q280 and +1.4% in Q480. Spreads today are wider than they were at the start of the year across all sectors (see Figure 1) and as value investors, we believe these market dislocations create opportunities for us to add alpha to your portfolios.
Today the Treasury market is discounting more than 250 bps of rate hikes over the next 12 months. This comes after we have already witnessed a dramatic repricing of yields, particularly in the short and intermediate part of the curve. Naturally yields can always go higher from here as investment is never without risk. If markets start pricing in more rate hikes, we can use the “breakeven yield” as one measure of potential downside risk. The breakeven yield is the yield to which bonds would have to rise for capital losses to offset the income earned over 12 months, resulting in a zero return. This varies by starting yield and bond maturity. If we look at the ICE BofA 1-3 Year US Corporate Index, yields would have to rise by 1.60% from the March 31 level of 2.86% to 4.46% – well above the last 10-year high of 3.65% – for investors to lose money on an absolute basis. After the significant repricing, the balance of risks is now much more attractive at these elevated levels. Arguably, the chances are even greater now than they were in 2018 that the Fed will not be able to complete the rate hikes the markets have priced in and investors will be able to earn more than the carry implied by current yields.
Inflation or not – we see opportunity
1980s style runaway inflation is looming in many people’s minds. It’s hard to believe that just about two years ago oil hit an all-time low of $-37.63/ barrel. Imagine being paid to own oil! Here we are now as oil hovers around $100 with prognostications of a $200 price tag, but the all-time high for oil was $147 in July 2008. As a countermeasure to higher oil prices, the Biden administration has started to release one million barrels of oil from the Strategic Petroleum Reserve per day for six months. But this is not a long-term solution as there are just too many unknown geopolitical factors that drive the price of oil. What we do know is that energy independence has become more in focus with the invasion of Ukraine and the response of different countries will surely vary. We are in the midst of a transition period from fossil fuels to renewable sources of energy. As we move through this transition, traditional fossil fuel companies are now more of a necessity than ever before and offer an investment opportunity.
Speaking of transitions, global supply chains are also in a transition phase. The move from just-in-time to just-in-case is permeating the global markets. The fact that Intel is building a $20 billion computer chip facility in Ohio is a prime example of the beginning of onshoring. Despite it being more costly to manufacture at home, the inflationary pressures we saw from chip shortages was extraordinary. It is estimated that the shortage of chips cost the auto industry $210 billion. Just look at the price increases we saw for used cars of 24.1% YoY for the month of March (see Figure 2). Who would have thought you could make money trading used cars?
Despite rampant fear of runaway inflation, expectations are that inflation will begin to fall during the second half of the year (see Figure 3). What might drive this scenario are resolutions of some bottlenecks in the supply chain, the Fed actively raising short-term interest rates and demand destruction from higher prices. Many commodity products are trading in what is called “backwardation,” which means the cash prices of the commodities are trading at higher prices than the future prices of the commodities. This suggests that demand is projected to fall relative to supply in the future. Thus, we believe that maintaining or even increasing your fixed income allocation when the fear of rising rates is at its peak is a value manager’s best play.
There has been a lot of chatter among television pundits about the inversion of the Treasury yield curve. In particular, the inversion of the 2s/10s curve (when the 10-year Treasury yields less than the 2-year Treasury), which occurred at the end of the quarter and only lasted a couple of days. The signal is commonly believed to augur an imminent recession. The reality is that an inverted 2s/10s curve does not tell you much about the timing of a recession.
In the past, the time between the start of the inversion and a recession has averaged about 20 months and in some cases has been longer than two years. The Fed recently published a report comparing the 3-month Treasury to the 3-month Treasury 18 months forward, which it refers to as the “near-term forward spread,” to the 2s/10s spread. To quote the Fed, “…we have provided statistical evidence indicating that the perceived omniscience of the 2-10 spread that pervades market commentary is probably spurious.” The Fed’s indicator is actually moving in the opposite direction of the 2s/10s curve; it is steepening (see Figure 4). Many a debate will ensue regarding which is the prescient indicator. What we do know for certain is that yields are substantially higher year to date. More importantly, spreads are wider across all sectors than they were at year end, presenting us with opportunities to add alpha.
Systemic risks may not materialize
As we look for the next catalyst to impact markets, we evaluate one of the more interesting components of our monthly sector scorecard meeting: “systemic risks.” Every month the team has a lively discussion on what factors could have an inordinate impact on market valuations over the next few months. One of the risk events we are closely monitoring is the speed with which the Fed embarks on Quantitative Tightening (QT), which includes raising the Federal Funds rate as well as normalizing the Fed’s balance sheet. Removing the unprecedented amount of liquidity in the US economy will not be an easy feat, nor one that financial markets react to kindly. As we look at our opportunity set, Agency MBS is a sector in which we currently have a significant underweight. Not only are the bonds sensitive to rates volatility but also to prepayment risk as rates move lower and extension risk as rates move higher. Demand for this sector will be heavily impacted by the loss of the largest buyer of Agency MBS, which has been the Fed over the last couple of years. The pace of reduction of Agency MBS ($2.7 trillion) from the Fed’s balance sheet is expected to be $35 billion per month. This excludes reinvesting the proceeds from maturities and principal paydowns. Attention will follow Fed communication with regards to the potential of outright Agency MBS sales at some point in 2023. The Fed’s $5.7 trillion holdings of Treasury securities are expected to decline at a pace of $65 billion per month – again by not reinvesting the proceeds from maturities and coupon payments. Looking at the Fed Funds rate, we started the year with the markets pricing in a June 15, 2022 Fed Funds rate of 45 bps; it’s now expected to hit 130 bps. 50 bps rate hikes are being priced into the markets with a peak Fed Funds rate priced to hit 3.2% in early 2023. If history has taught us anything, the Fed does not have the best track record of soft landings and while roughly 10 hikes are priced into markets over the next 12 months, we do not believe the Fed will achieve them. As a result, our expectations are that: 1) fixed income returns in H2 will be more appealing than in H1 and 2) there will be volatility in markets, which should result in opportunities to add risk across sectors.
Municipals may have their moment
If there is one factor that has consistently impacted the relative valuations of municipal bonds, it is the fear of rising rates. 2021 was a spectacular year for municipal bond performance. Inflows of $100 billion and light tax-exempt municipal issuance aided performance. This quarter, on the other hand, the municipal bond market has been plagued by outflows of $22 billion as retail investors reacted quickly to the rise in rates. Despite a solid fundamental backdrop (see Figure 5) resulting from both Federal stimulus dollars lining municipal coffers to the meteoric rise of the economy driving higher income, sales and property taxes, the municipal market suffered one of its worst quarters.
The municipal market reported a -6.2% loss for Q1 2022, the worst quarter in 40 years, a dramatic reversal after a strong performance in 2021 (+1.5%). Performance through quarter end is in line with global bonds as interest rates rose in response to the highest inflation in four decades. Using our relative value metric for municipal bonds, the Net Implied Tax rate (NIT), you can see how municipals have moved from being the most expensive to still modestly below fair value (see Figure 6). As the broader markets digest QT, rest assured that the municipal bond market has shown us time and time again that it too will react. Perhaps this will be the year that we see a sector rotation opportunity to buy tax-exempt municipal bonds in accounts that do not pay taxes. Dare we say Taper Tantrum 2.0?
High yield: still a sure thing?
The environment for investing in high yield corporates has been very favorable over the last few quarters. Generous valuations, falling defaults and tailwinds fueled by a combination of accelerating earnings and central bank support bolstered them. While there is no impending cause for panic, it is probable that many of these supports are likely to become headwinds in the coming quarters. In particular, the relative value seems to have moved more in favor of investment grade in recent weeks (see Figure 7) and we have tempered our high yield exposures accordingly.
Although the sector continues to benefit from a domestic focus, bias toward commodity-heavy sectors, such as energy (around 13%), and improving ratings trajectory (roughly 50% BB-rated), we believe much of this is already reflected in valuations. High yield spreads, although off the lows of late last year, have been a conspicuous outperformer during recent volatility, especially relative to investment grade corporates. With growth slowing, earnings growth having peaked and a Fed intent on tightening financial conditions, we believe the risk/reward for the sector is less attractive than it has been in several quarters.
Emerging markets – pick your spots
The tragic escalation of events in Ukraine has been front and center in emerging markets over the first few months of the year and has seen precipitous returns for countries directly involved. However, more broadly, emerging markets have had an encouraging start to the year, specifically in local currency markets, which we had highlighted as an opportunity last quarter and continue to favor at this time. In particular, we continue to see value in South America and countries such as Mexico and Brazil, which benefit from commodity-heavy economies, improving trade balances and attractive valuations.
The local currency emerging markets sector continues to be an area of relatively attractive valuations as many emerging markets countries are further through the policy tightening phase than developed countries. We also believe that the dollar will shift from a headwind to a tailwind this year given the Fed rate hiking cycle as the dollar typically strengthens through the first rate hike but then weakens. More importantly, there is a lagged relationship between the US’s current account and budget deficit, which ballooned during Covid. The combination of a structurally weaker dollar and a more favorable growth differential would likely provide decent support for the asset class, both in dollar and non-dollar emerging markets. Figure 8 shows the real yield advantage of emerging markets as compared to the US. If our US dollar view is correct, non-dollar emerging markets assets should be poised to benefit.
Stability in a higher yielding world
As rates rose and spreads widened during the quarter, we took the opportunity to shift modestly out of Treasuries and agency MBS to a lesser degree, and into corporates across the platform. In our tax-aware strategies, we increased our allocation to tax-exempt municipals, which underperformed other risk assets during the quarter, using corporate bonds as a funding source. We have been cautious in our allocations given the uncertainties in the market during the quarter, which were exacerbated by the invasion of Ukraine. As markets settle, we continue to evaluate the evolving macro landscape and fundamental backdrop and will adjust our exposures when we see attractive opportunities.
There is an old Wall Street adage, “Buy to the roar of cannons and sell to the sound of trumpets.” As value managers, we are predisposed to look at the markets through a different lens. The dramatic shift in market valuations this past quarter across all fixed income sectors is a welcome sight that has been absent for the last several quarters. The fundamentals tell us that corporate and municipal balance sheets are in great shape. The technical dynamic, on the other hand, is the big storm cloud looming on the horizon. We are well positioned for the storm, with dry powder in the portfolios to redeploy when panicked investors sell or new issues are priced with eye-popping concessions. As we have seen in the past with each crisis we have navigated, the storms do pass, and sunny skies follow. Not sure if anyone on the team is much of a trumpet player but identifying value is our expertise.
The views and opinions contained herein are those of Schroders’ investment teams and/or Economics Group, and do not necessarily represent Schroder Investment Management North America Inc.’s house views. These views are subject to change. This information is intended to be for information purposes only and it is not intended as promotional material in any respect.