The Absolute Opportunity in Fixed Income Surges

First-quarter fixed-income absolute returns were at their lowest in nearly 40 years. Five-year Treasuries moved from a yield of just over 0.5% last summer to almost 3% in April. While no one likes to see negative absolute returns, the opportunity and yields now available to investors are more attractive than they have been at any point in the last 10 years (excluding the 2018 Fed-hiking cycle).

With inflation peaking and a very aggressive path of Fed hikes already discounted into markets, we believe fixed-income forward returns could potentially be much more favorable. If markets remain stable or yields drop, investors stand to earn greater returns than we've experienced in most of the last decade. In addition, there’s now a significant margin for error (or cushion) if another adverse move in rates/credit spreads occurs.

The quarter began with historically tight corporate spreads and only three Fed-rate hikes priced into the Treasury market through early 2023. The 2022 fundamental backdrop was positive: GDP consensus forecasts were at a healthy 4%, Core Personal Consumption Expenditure (PCE) Index forecasts were at a manageable level of 3.3%, +20% yoy expected corporate earnings in 4Q21, and corporate leverage was trending lower. The economy was relishing in a tailwind of trillions of dollars of fiscal and monetary stimulus.

Despite these expectations, the absolute return of the Bloomberg US Aggregate Bond Index in 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 basis points (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%. The subsequent quarters, however, experienced absolute returns that were positive: +19.8% in 2Q80 and +1.4% in 4Q80.

Spreads today are wider than they were at the start of the year across all sectors (FIGURE 1), and as value investors, we believe these market dislocations create opportunities to add alpha to your portfolio.

Today the Treasury market is discounting more than 250 bps of rate hikes over the next 12 months. This comes after witnessing 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 look to 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.

For example, for investors in the ICE BofA 1-3 Year US Corporate Index to lose money on an absolute basis, 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%.

After the significant repricing, the balance of risks at these elevated levels is now much more attractive. Arguably, the chances that the Fed is unable to complete the priced-in rate hikes and that investors will be able to earn more than the carry implied by current yields are even greater now than they were in 2018.

Inflation or Not—We See Opportunity

It’s hard to believe that two years ago oil hit an all-time low of $-37.63/barrel, as prices are now hovering around $100 with some $200 projections. (The all-time high for oil was $147 in July 2008.) To counter higher oil prices, the Biden administration has begun to release one million barrels of oil per day for six months from the Strategic Petroleum Reserve. This, however, isn’t a long-term solution as there are many geopolitical factors that drive the price of oil.

Though we’ve already begun transitioning from fossil fuels to renewable resources, the invasion of Ukraine has further spotlighted the desire for energy independence. Traditional fossil-fuel companies are now more of a necessity than ever before and offer an investment opportunity.

Global supply chains are also in a transition phase: The move from a just-in-time inventory-management strategy to a just-in-case strategy is permeating markets. Intel’s $20 billion computer chip facility project in Ohio is a prime example of the beginning of onshoring. Despite being more costly to manufacture at home, the inflationary pressures we saw from chip shortages was extraordinary. It’s estimated that the chip shortage cost the auto industry $210 billion, and it skyrocketed the price of used cars—jumping 24.1% in March 2020 alone (FIGURE 2).

Despite rampant fears of runaway inflation, inflation is expected to fall during the second half of the year. Supply-chain bottleneck resolutions, short-term interest-rate hikes, and demand destruction as a result of higher prices could all be factors in falling inflation.

Many commodity products are trading in backwardation (i.e., the cash prices of the commodities are trading higher than prices trading in the futures market), suggesting that demand is projected to fall relative to supply in the future. Thus, we believe it may be prudent for a value manager to maintain, or even increase, fixed-income allocation when the fear of rising rates is at its peak.

Curve Inversion

The recent temporary inversion of the 2s/10s Treasury yield curve (when the 10-year Treasury yields less than the 2-year Treasury) has been the topic of much discussion. Though this is commonly believed to signal an imminent recession, the reality is that an inverted 2s/10s curve doesn’t tell us much about the timing of a recession.

Historically, 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, the 3-month Treasury 18 months forward (which it refers to as the “near-term forward spread”), and the 2s/10s spread. To quote the Fed, “We’ve 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 moving in the opposite direction of the 2s/10s curve—it’s steepening (FIGURE 3). Many a debate will ensue regarding which is the prescient indicator, but 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

In evaluating systemic risks, we’re closely monitoring the speed with which the Fed embarks on quantitative tightening (QT), which includes raising the federal funds rate as well as normalizing its balance sheet. Removing the unprecedented amount of liquidity in the US economy won’t be an easy feat, nor one that financial markets react to kindly.

Within our own opportunity set, we’re significantly underweight to Agency Mortgage-Backed Securities (MBS). Bonds are sensitive not only to rate 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 recent buyer of Agency MBS—the Fed. 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. Many will be on the lookout for Fed communication regarding potential 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.

The year started with markets pricing in a June 15, 2022 federal funds rate of 45 bps, and it’s now expected to hit 130 bps. Rate hikes of 50 bps are being priced into the markets with a peak federal funds rate priced to hit 3.2% in early 2023. The Fed doesn’t have the best track record for soft landings, and while roughly 10 hikes are priced into markets over the next 12 months, we don’t believe the Fed will achieve them. As a result, our expectations are that: 1) fixed-income returns in the second half of the year will be more appealing than in the first half, and 2) there will be volatility in markets, which could result in opportunities to add risk across sectors.

Municipals May Have Their Moment

Fears of rising rates is one factor that has consistently impacted the relative valuations of municipal bonds. 2021 was a spectacular year for municipal-bond performance as inflows of $100 billion and light tax-exempt municipal issuance aided performance.

This quarter, 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 resulting from both federal stimulus dollars lining municipal coffers and the meteoric rise of the economy driving higher income, sales, and property taxes (FIGURE 4), the municipal market suffered one of its worst quarters.

In Q1 2022, the municipal market reported a -6.2% loss—the worst quarter in 40 years and a dramatic reversal after a strong 2021 performance (+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. Our relative-value metric for municipal bonds, the Net Implied Tax Rate, shows that municipals have moved from being the most expensive to still modestly below fair value (FIGURE 5). As the broader markets digest QT, the municipal-bond market has historically shown 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 don’t pay taxes. Dare we say Taper Tantrum 2.0?

High Yield: Still an Attractive Opportunity?

In recent quarters, the environment for investing in high-yield corporates has been very favorable, bolstered by generous valuations, falling defaults, and tailwinds fueled by a combination of accelerating earnings and central-bank support. While there’s no impending cause for panic, there’s potential for many of these supports to soon become headwinds. In particular, the relative value seems to have moved more in favor of investment grade (IG) in recent weeks (FIGURE 6), and we’ve tempered our high-yield exposures accordingly.

Although the sector continues to benefit from a domestic focus, a 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 IG 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 (EM) over the first few months of the year and has seen precipitous returns for countries directly involved. However, more broadly, EMs have had an encouraging start, specifically in local-currency markets, which we highlighted as an opportunity last quarter and continue to favor at this time. 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 EM sector continues to be an area of relatively attractive valuations as many EM countries are farther along the policy tightening-phase than developed countries. We also believe the US dollar will shift from a headwind to a tailwind this year given the Fed’s rate-hiking cycle, as the dollar typically strengthens through the first rate hike before weakening thereafter. More importantly, there’s a lagged relationship between the US’s current account and budget deficit, which ballooned during COVID-19. The combination of a structurally weaker dollar and a more favorable growth differential could provide decent support for the asset class, both in dollar and non-dollar EMs. FIGURE 7 shows the real yield advantage of EM compared to the US. If our US-dollar stance is correct, non-dollar EM assets could 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, to a lesser degree, Agency MBS, and shift 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’ve 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 as we see attractive opportunities.

As value managers, we’re predisposed to look at the markets through a different lens. The dramatic shift in market valuations across all fixed-income sectors this past quarter is a welcome sight that has been absent for the last several quarters. Fundamentals show that corporate and municipal balance sheets are in great shape. The technical dynamic, however, is the big storm cloud looming on the horizon. We believe we're well-positioned to weather the storm, and we're ready to redeploy dry powder in our portfolios when panicked investors sell or new issues are priced with eye-popping concessions. As we’ve seen, storms eventually pass, and sunny skies follow.