Altium's Update on Fixed Income Markets
Fixed income markets have been under pressure this year as investors wrestle with persistent inflation and the early stages of an aggressive Federal Reserve (Fed) tightening cycle. Inflation levels were elevated coming out of the pandemic only to intensify this year due to supply chain disruptions as a result of the Russian invasion of Ukraine and Covid related shutdowns in China. Bond prices, which move in the opposite direction to yields, have declined significantly with some segments of the bond market falling more than we have seen in decades.
We continue to believe that an allocation to fixed income in a diversified portfolio plays a significant role within a long-term investment strategy. Furthermore, we have prepared for this type of fixed income environment within our allocation design and we currently see attractive opportunities in some sectors of the market.
2022 Fixed Income Markets
Index returns :
Fixed Income Asset Class Returns as of May 11, 2022
What's Going On?
Financial news outlets have been closely reporting on the treasury bond yield curve, which plots yields for treasuries of all maturities. Though constantly changing, this curve is a tool investors can use to get an idea of future interest rate changes and a sense for overall economic activity. The chart below shows the yield curve as of 12/31/21 (Gold) and how it looks today 5/12/22 (Green). As the chart indicates, yields have shifted higher across the curve, partly as a result of the Fed’s recent guidance and activities.
Yields on 2-year Treasuries are reflective of where the Federal Reserve sees short term rates in the next 2 years. Notably, the current curve in Green has steepened from 1 month out to 2 years, and is relatively flat from 2 years out to 10 years. The yield on 2-year Treasuries has risen by 1.86% this year and is now 2.6% as of 5/12/22. The rise in yield on the 2-year Treasury bond has resulted in poor performance on short dated bonds which has caught many by surprise as the risk is generally perceived to be very low in these types of securities.
Many investors focus on the shape of the yield curve and its ability to forecast a recession. Most focus is on the spread between 2-year and 10-year bonds which is relatively tight at 29 basis points (bp). This part of the curve actually inverted earlier this year when the yield on the 10-year Treasury was lower than the yield of the 2-year Treasury. An inversion of the 2/10-year curve sounds an alarm to some investors of a looming economic downturn. Fed chairman Jerome Powell has referenced research by staff in the Fed system that the short end, the first 18 months of the yield curve, is a much better indicator. As the chart below shows, the 18-month section of the curve remains steep and is a true indication of what the Fed will do in the next 18 months. This is in contrast to the longer term 2/10-year portion of the curve that is much flatter. If the short end of the curve were to flatten or invert, it would be an indication that the Fed will stop raising rates or even cut rates to address a slowdown.
Altium’s fixed income team uses this analysis as one tool to understand where interest rates will be going in the short term and the effects of these rates on longer term economic growth.
Treasury Yield Curves as of 12/31/21 and 5/12/22
Source: Bloomberg; US Treasury Curve
What Are We Doing?
Coming out of the pandemic, we assumed that inflation and tighter Fed policies were a possibility down the road. As we have mentioned in prior quarterly letters, we have looked to manage the duration and credit quality of our fixed income portfolios to manage the volatility in this type of environment. Over the past 18 months, we had increased our exposure to inflation protected securities and floating rate securities while maintaining higher than average credit qualities relative to benchmarks. We also find it advantageous to own individual bonds to dampen the effects of rising/falling interest rates when held to maturity. As long as we hold the bonds to maturity, and we are not forced to sell, we can ride out the price volatility and earn a positive return as the bonds mature or are called. In this current environment, as bonds mature, we are using the proceeds to buy new longer dated bonds at significantly more attractive yields.
What To Expect Going Forward
At the Fed’s May meeting last week, the FOMC voted to raise the Federal Funds target rate by 50 bps while signaling similar 50 bp increases at the next couple of meetings in June and July. Market consensus is implying the Fed Fund policy rate will be approximately 2.75% at year-end (from its current level of 0.75%). The bond markets are forward looking, and if an investor is optimistic that inflation has peaked, much of these expected interest rate increases are priced into the market. In this scenario, while markets will remain volatile, we would not expect significantly more downside in bonds. A risk to this thesis is that the Fed is not able to tame inflation and has to raise interest rates more than the market expects. The Fed will be walking a tight rope as they look to rein in inflation while avoiding slowing economic growth to the point of putting the economy into a recession.
What Opportunities Exist in the Bond Market Today?
The recent decline in bond prices has rattled many investors. We do not believe in market timing as it is nearly impossible to pick tops and bottoms in markets. However, we see some attractive opportunities in different segments of the bond market that offer yields we have not seen in years with attractive risk/reward profiles. Intermediate term (5-7 year) investment grade corporate bonds look attractive after the sharp decline in prices this year. Prices we are currently seeing in the market indicate we could build a portfolio with a yield of roughly 4% and a duration of under 4.5. This looks like an attractive yield in high quality bonds without taking significant duration risk. Municipal bonds are also very attractive at the moment as they have underperformed Treasury bonds year to date. We monitor 10-year municipal bond yields as a percentage of similar maturity Treasury bonds. This ratio which has historically averaged 75-80% due to the tax-exempt nature of municipal bond interest is currently approaching 99%. This means we can buy high quality municipal bonds with yields at 3.0-3.5% which equates to taxable equivalent yields of 5.0-5.5% for investors in higher tax brackets. These yields look very attractive compared to the yields on 10-year municipal ladders that were below 1% at year-end 2021. The credit risk on these high-quality municipal bonds is very low due to the strong balance sheets of most state and local governments after receiving multiple rounds of Federal support during the pandemic.
The sharp negative move in fixed income prices to start the year has surprised many investors who have been accustomed to little price variability of their bonds. While the move has been extreme relative to historical norms in the fixed income markets, we remain confident in the role fixed income plays in some client portfolios.
Our fixed income team is closely monitoring the various segments within the fixed income asset class and we see opportunities for investors where fixed income allocations are appropriate.
Head of Fixed Income
1 - Source: Bloomberg US Aggregate Bond Index (LBUSTRUU); Bloomberg US Treasury Index (LUATTRUU); Bloomberg US Corporate Bond Index (LUACTRUU); Bloomberg US Municipal Index (LMBITR); Bloomberg US Corporate High Yield Bond Index (LF98TRUU); Bloomberg Global Aggregate Index (LEGATRUU).
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The performance results presented herein simply reflect the performance of various benchmark indices over a period of time and do not represent any actual performance results of Altium. Past performance is no guarantee of future results and there can be no assurance that any particular strategy or investment will prove profitable. Indices are unmanaged. Any reference to a market index is included for illustrative purposes only as it is not possible to directly invest in an index. The figures for each index reflect the reinvestment of dividends, as applicable, but do not reflect the deduction of any fees or expenses, or the deduction of an investment management fee, the incurrence of which would reduce returns. It should not be assumed that your account performance or the volatility of any securities held in your account will correspond directly to any comparative benchmark index. Bonds and fixed income investing involves interest rate risk. When interest rates rise, bond prices generally fall.