A fixed income strategy to carry investors thru the months ahead

After a year of solid performance in 2021, fixed income has experienced significant drawdowns in 2022 amid increasing inflation and the most aggressive Federal Reserve (Fed) monetary tightening policy in decades. Fears and concerns about inflation, the Fed’s rate-hiking cycle and a looming recession will continue to drive valuations. However, a difficult year in the markets has created opportunities for value-oriented fixed income investors. Consequently, we will prudently scale into sectors where we see the most value and seek to capitalize on the best after-tax opportunities as they arise.

As we anticipate the new year, we believe state and local governments will have a modestly less favorable fundamental position given the broader macro forces at play. Importantly, issuers are still flush with cash due to strong tax revenues and the federal aid they received in the last two years; they are sitting pretty on strong budgets. With federal money in their wallet and hardy balance sheets, we believe issuers will weather volatility quite well in the coming months. For example, at the state level, rainy day funds reached near record levels in fiscal 2022 (see Figure 1), which bodes well for issuers that are heading into an uncertain economic situation in 2023.

Figure 1: Rainy day fund balances as a percentage of expenditures fiscal 2000 to fiscal 2023

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Source: NASBO. Historical trends are not indicative of future results. Forecast may not be realized.

Currently the drivers of the municipal market remain technical rather than fundamental. Through early November, the market experienced mutual fund outflows for thirteen consecutive weeks. As Figure 2 illustrates, year-to-date outflows reached a new record of $103 billion (their peak level since the data series began in 1992), more than offsetting 2021’s record inflows of $102 billion. Additionally, issuance is notably slower than last year for both tax-exempt and taxable bonds due to higher rates. Retail investors have exited the market, but professional investors can take advantage of this technical weakness because it has led to attractive valuations.

Figure 2: Municipal flows (in billions; since 1992) reversed course in 2022 as rates rose

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Source: Lipper as of October 5, 2022. Current trends may not continue or lead to favorable investment opportunities.

Figure 2 illustrates that 2022 has been a record year of outflows since Lipper first began collecting this data in 1992.

Figure 3: After-tax sector returns

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Source: Bloomberg Indices; top federal tax rate applied. Historical returns are not indicative of future results. *As of September 30, 2022.

Figure 3 depicts how difficult the year has been for fixed income and how underperformance has created an opportunity for us to scale into a weaker market across multiple sectors. While many investors may be tempted to sell fixed income, assets based on this weakness, we believe it is wise to remain disciplined with regard to our investment process and take advantage of value opportunities.

Figure 4: 30-year municipal yields as a % of 30-year Treasuries
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Source: Bloomberg as of September 30, 2022. Historical trends are not indicative of future results.

One indicator we use to help determine value in municipal bonds relative to other fixed income assets is the Muni/Treasury ratio. This indicator is now pointing to a pocket of opportunity on the long end of the curve. Without having to surrender credit quality to gain yield, we are seeing attractive valuations among higher rated credits. With the threat of a recession on the horizon, we prefer the higher quality names with strong fundamentals. Figure 4 demonstrates that the ratio has generally exhibited an upward trend since last year, which tells us municipal bonds are getting cheaper compared to Treasuries.

It is not just tax-exempt municipals where we are seeing opportunities. Valuations of corporates and agency mortgage-backed securities are similarly attractive amid the recent widening in credit spreads. With Treasury yields as high as they are, there is less need to extend out the risk spectrum, particularly as the US economy is likely to enter an economic recession in the coming months.

Instead, we prefer to focus on three areas of the market that offer value: 1. long duration municipal bonds; 2. agency mortgage-backed securities; and 3. short maturity investment grade corporate bonds. The opportunistic nature of this strategy means that active sector rotation is crucial in this market environment. By positioning our portfolios in favor of these investments, we retain ample liquidity to quickly deploy as we identify attractive opportunities. This is the advantage of a multi-sector fixed income portfolio.  

While the challenges the market has faced are staggering, we can all take heart in future opportunities. As the economy hits the brakes and inflation crests, we believe the opportunity in fixed income is considerable. However, in this market, patience is the name of the game. Opportunities will continue to present themselves as the tide of liquidity continues to recede. As always, we remain patient and poised to pull the trigger when opportunities materialize.


Topics:

  • Fixed Income
  • Interest Rates

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.