Written by: JB Golden | Advisor Asset Management
With the year winding down, fixed income markets are likely ready to forget what a historically bad year it has been by just about any measure. There is certainly no lack of pontification on just how bad, with many market observers harkening back 200 years or more to declare it the worst bond market in history. Without a significant rally heading into year-end, most bond markets will likely post the worst returns since at least 1973 and many will likely post returns on a yearly basis that are worse than the last round of elevated inflation in the early 1980s. As of the close on November 15th, 2022, the Bloomberg US Corporate Bond Index was down 16.86% year-to-date, by far the worst return since records began in 1973 and almost three times the previous worst year of 5.86%, also in 1973. The US Treasury market is not faring any better down 12.88% year-to-date (as of 11/15/2022) which is three and half times the -3.57% in 2009, the worst year since 1973 for US Treasuries. Not to be left out in the cold, US Tax-Exempt municipals are down -10.66% year-to-date with the worst year for the Bloomberg Municipal Bond Index being -10.23% in 1981, marking the only investment grade fixed income asset class that might avoid “worst on record status” in 2022. To be fair, there were quarters in the early 1980s that outpaced anything we have seen in 2022, for instance Investment Grade Corporates down -10.785% in Q1 1980.
Suffice to say it has not been a fun year for bonds. Increases in interest rates this year rival anything on record. Adding to the pain were the low yields of the bond market at the beginning of the year combined with the rapid pace of interest rate increases throughout the year. Yield-to-maturity or a related measure such as yield-to-worst is the best predictor of a bond’s expected total return. The larger the starting yield the higher the expected return with the flip side being the higher the starting yield the larger the cushion against rate volatility. Bond markets started the year with the lowest yield-to-worst levels in history providing little to no cover against higher rates. Furthermore, the slower the pace of rate increases the more compounding interest accrues to offset price losses. The rapid pace of increases in 2020 left a short time horizon over which to accrue interest. Moreso than the increase itself, low yields and the rapid pace of rate increases made the losses especially acute in 2022.
Moving into 2023 there are some signs of relief for bond markets and silver linings are beginning to emerge. The large increases in interest rates have brought about the death of TINA (There Is No Alternative) to stocks. Now bonds are back, providing a meaningful income-producing alternative to equities. Yields in Investment Grade Corporates, Tax-Exempt Municipals and High Yield all sit near decade-plus highs, levels touched only briefly since the Great Financial Crisis in 2008. Treasury market rates on the short-to-intermediate portion of the yield curve now sit well over two times the dividend yield on the S&P 500. Credit fundamentals in investment grade markets are still strong. After a decade of easy money policy, investment grade corporate issuers have been able to push out debt walls. Recent fiscal aid along with the post-COVID recovery in sales and tax receipts has bolstered the credit fundamentals of state and local governments. Bond markets have also shown strong reversion potential coming out of down years. Municipals have also shown strong mean revision on the heels of fund outflow cycles. 2022 marked the worst outflow cycle in the history of the municipal markets. Finally, higher grade bonds such as Investment Grade (IG) Corporates and Municipals could provide some shelter should we see a recession in 2023. There is a plethora of reasons bonds are back and back in a big way, and there seems to be little disagreement that bonds are attractive at current valuations. However, when duration/interest rate risk is thrown into the mix, the situation gets murkier. By far the biggest “what/if” of the year has been when and how much duration to add in fixed income portfolios. While a growing comfort with duration is likely warranted, we believe adding duration incrementally on weakness could be a strong strategy, however, there are still reasons to be cautious on duration.
November is shaping up to be a good month for bonds. That said bond markets might be getting a little over the skis at this point given the backdrop on labor markets and inflation which could warrant continued caution on the duration front. As of November 15th, Municipals are up almost 3.5% on the month and IG Corporates are up over 4%, both of which would easily be the best monthly returns of the year. The backdrop is reminiscent of the July 2022 market when exuberance around a potential pivot by the Fed, drove both equity and bond markets on to their best month of the year by far. The July enthusiasm was short-lived though as Fed officials, at the annual Jackson Hole meeting in August, promptly threw cold water on any notion that a pivot was in store.
The November rally is being driven by the same factors. Recent economic data, including the most recent CPI print, would seem to indicate peak inflation may be in the rearview mirror. In addition, recent comments from Federal Reserve officials have been interpretated as an indication a slightly gentler monetary policy, relative to the last year, may be in store. As such, it should not be a surprise that bonds and equities have rallied in November on the news. That said in a virtual repeat of July, Fed officials, namely James Bullard, were quick to remind markets last Thursday that further hikes would be necessary, and the Fed Funds rate would likely need to be somewhere between 5%-7% before inflation was under control. Bonds promptly sold-off right alongside equities in as markets re-priced the expected path of monetary policy.
It may be true that we are both entering the next phase of monetary policy and should expect more rate hikes. Markets seem to have latched on to the notion that the Fed may be close to a “pivot” but unfortunately that still leaves an ocean of room open for interpretation. Given the continued strength in the labor markets, continued strength of the US consumer and inflation still at elevated levels, we are likely not in store for a pause just yet. We certainly don’t seem to be near a pivot to rate cuts. This seems to be the dose of reality posited by Mr. Bullard last Thursday. It could be helpful to consider a “pivot” as consisting of several phases. The first phase, which may be close, is a slower pace of rate hikes, not a pause or a move to cut rates. Without more convincing evidence that the Fed is slowing demand in the labor market and/or making more progress on getting inflation back to at least the prevailing rate of Fed Funds, there is going to be a tremendous amount of uncertainty as to the potential timing of phase two (pause) and phase three (rate cut). The inversion of the yield curve (2s-10s) is telling investors the same and the 2s-10s inversion reached the deepest level in 40 years with the bond market sell-off late last week. Bond markets aren’t buying the notion the Fed is near even a pause and it could be prudent to table any talk of a pause or a pivot to rate cuts before the yield curve begins to re-steepen.
The adage “Don’t Fight the Fed” comes to mind and, in this case, it might be prudent to take the Federal Reserve at their word, which would dictate some continued caution on longer durations. While an appetite for longer duration out past the context of short-to-intermediate may be on the horizon in 2023, for the time being, we would keep some powder dry and wait for more clarity on the timing of any potential pause or pivot to rate cuts.
Related: MBS, Convexity Vortex, and a Silver Lining for Bonds