Stay tuned, stay nimble
After years of playing defense, it's time to think offense.
As with taxable bonds, muni market volatility and deep losses have driven a record pace of fund redemptions this year. The first and second quarters were difficult, with the S&P Municipal Bond Index return -8.4% for the first six months! However, once U.S. Treasury yields appeared to reset from a one-way train higher to a range trade during June, muni yield ratios relative to intermediate and long-term Treasuries had cheapened enough to attract investor capital. The prospect of better returns has prompted some new thinking. With the 30-year BVAL AAA muni yield at 3.25% at the end of June, investors face a much better risk/return than when that same yield was 2.60% at end of Q1 and 1.54% at year-end 2021. Sure, inflation remains extremely high, but the market expects it to retreat amid the Fed’s hawkishness and the slowing economy. With muni fundamentals still strong, credit spreads cheaper and initial yields higher, the landscape for reasonable returns in munis has improved. Of course, should inflation remain much too high (around current levels and not showing signs of retreating rapidly), that sentiment could be dashed yet again. For now, however, there are reasons to be optimistic for near-term returns.—R.J. Gallo
On June 14, the day before the Fed hiked policy rates a rare 75 basis points, the Federated Hermes fixed-income duration committee shifted from a defensive interest-rate position to neutral for the first time since pre-Covid days. The move came after the 10-year Treasury yield jumped 74 basis points to 3.48% (the highest yield in over a decade) and the 5-year yield an even larger 88 basis points to 3.50% over the prior 12 trading days. Also factoring into the call: Street whispers that the first three-quarter-point increase since 1994 was all but certain the following day. The duration committee expects to be more tactical as rates remain volatile. But the easy money has been made as, after a year of dallying as price pressures worsened, the Fed finally made clear that it’s committed to bringing down 40-year high inflation, even at the risk of recession. We believe its determination will become even clearer at this month’s policymakers’ meeting, where another three-quarter hike, or even a 100 basis-point increase after June’s high CPI, appears likely.
The message for fixed-income markets? The worst of Treasury market declines—first-half returns for Treasury bonds were never so bad since the U.S. Constitution was ratified in 1788—are behind us. With yields largely repriced out the curve to levels consistent with an aggressive Fed, it should be a more two-sided market going forward, not the one-way/rising-yields version of the last 2+ years. This means it’s time to start thinking offense. Even if rates keep rising, there is now at least a reasonable level of income to offset potential price declines, with the yield to maturity on the Bloomberg US Aggregate Bond Index topping 4% (it was under 1% just two years ago). Thus, while yield increases of even just a few basis points in 2020 and 2021 would offset low levels of income, causing near-record levels of negative total returns, it would take market yield increases above 4% over the next 12 months to make fixed-income total returns negative.
Underweight credit, laddering across Treasuries
We’re not saying Treasury yields won’t go higher. But we do believe yield activity of late aligns with our view that the biggest increases have passed. Both 10- and 30-year Treasury yields have hooked down significantly off their mid-June highs for the year, when uncertainty about the Fed’s commitment reigned. And the 5-year TIPS breakeven rate briefly dipped below 2.5% this month, more than 100 basis points below its mid-May peak. All this suggests the market believes in the new Volcker-esque devotion to fighting inflation by Chair Powell et al. The treatment is sure to cause economic pain—inflation looks to be sticky and remain above the Fed’s 2% for some time. But it’s potentially bullish for Treasuries.
Not so, credit. Which is why for the first time since 2008, we are underweight our big spread sectors (investment-grade and high-yield corporates, and emerging markets). While spreads—the difference in yields to comparable maturity Treasuries—have widened across the fixed-income sectors, an elevated inflation/slowing economy presents challenges, meaning these areas still have some repricing to do, much as already has occurred with Treasuries. The bias is for credit yields to go higher here. But we would be surprised if they gapped out anywhere near 2008 and 2020 Covid crisis levels as corporate profits continue to grow, bond defaults have been low and nominal GDP growth is running above trend (despite a possible technical recession if real second-quarter growth comes in negative, as it has been tracking, on top of the first-quarter’s contraction). Moreover, corporates aren’t vastly exposed. Empirical Research estimates large-cap companies (excluding financials and real estate) borrowed almost 90% of their outstanding debt at fixed rates well below today’s levels, with an average weighted maturity of eight years.
Bringing out the offensive playbook
With the biggest rate moves in the rearview mirror, Treasuries should offer value in the back half of the year. As much as slowing growth/rising recession risk represent headwinds for credit, they’re tailwinds for Treasury markets. Our fixed-income models have been laddering in holdings across the Treasury curve. We also see value in trade finance and asset-backed securities, and our biggest overweight is in agency mortgages, where credit risks are low, yields and spreads are attractive, extension risk (deferral of prepayments/refinancing) already has been realized and potential bank demand should offset a pending gradual Fed exit. We believe the strong run-up in the dollar—it reached parity with the euro this week—offers tactical opportunities as well, as the currency has been in a one-way trade for some time. The bottom line: after years of playing defense, we’re starting to call some offensive plays. It feels good getting reacquainted with the largest part of the fixed-income market and feels even better that fixed-income total returns should be more attractive for investors.