In the Fed We Trust
January 25, 2022 | Cameron Parkhurst
It’s crazy to think that January is already coming to a close. The opening chapter of 2022 has certainly been interesting, with our Federal Reserve crew seemingly becoming more hawkish by the minute. Much of this is due to lingering inflationary numbers, but also a seemingly rosy employment picture. Outside of jobs numbers and corporate earnings, we also have seen another wave of COVID-19, as well as evolving geopolitical risks with the unfolding developments in Russia. All of the above will contribute to a feedback loop which will drive our markets directionally. This month, we have seen a broad equity market selloff (led by tech) and have watched interest rates rise while also experiencing a flattening yield curve.
We will take a few minutes to unpack all of this. Importantly, we will discuss how one can continue to provide good income to portfolios while avoiding some of the pitfalls associated with the current fixed income market environment. Lastly, we have fielded a number of questions recently about a topic of Net Asset Value risk in periods of rising rates. Thus, we feel it’s a good time to revisit the topic with all our Advisors and have a detailed discussion therein.
First, let’s discuss the Fed. This week could prove to be very important, as the central bank will release its quarterly projections for the economy, inflation, and interest rates on Wednesday afternoon. This release and follow-up commentary by Fed Chair Jerome Powell will be closely watched, as many expect him to telegraph the path of future rate moves when addressing reporters post data release.
One key component that the Fed is struggling with involves inflation. This discussion is beginning to sound like Groundhog Day to some extent. We have been beating this drum throughout 2021 and so far this year, have yet to see any second derivative change regarding inflation numbers rolling over.
The delicate line that the Fed will have to walk here is one involving how they will attempt to bring down consumer price growth without causing a recession. If you recall from past missives, the Fed is targeting a 2% average inflation number and a 4% employment threshold. Inflation currently exceeds the central bank’s 2% target by a long stretch and is essentially dictating their upcoming moves. Price stability, not market stability, is now the key component of the Fed’s dual mandate. Powell and Company have often said that they must keep inflation closer to this 2% threshold to allow the economy to have the opportunity to achieve maximum employment. We expect this point to be well advertised by the Fed chair this week.
Many analysts believe that the high inflation numbers, caused primarily by supply chain constraints, should be easing soon. If the supply side were to ease, it could allow the Fed to achieve their mandate while not having to ratchet up rates as much as some market pundits believe that they currently might have to. This could help to avoid the unfortunate side of the feedback loop which could lead to a more substantial slowdown or even a recession in quarters to come.
The median forecast among Fed officials involves three quarter-point rate increases this year.
However, as late as last week, some analysts were calling for four rate increases in 2022, as well as a mention or two about a surprise 50 basis point increase potentially coming in March. We do not think that any 50-basis point increase is in the cards. If it were to happen it would shock the markets unnecessarily and cause panic.
The way the line is walked by the Fed will have broad based market implications, in both fixed income and equity allocations. We have already seen NASDAQ and the S&P 500 enter correction territory, with losses of over 10% from their respective highs as the calendar rolled over into the new year. Many of these same markets did well over the last handful or more years with very tame inflation.
The Fed ultimately has it on their shoulders to calmly restore lower, positive inflationary levels through their action.
Outside of the inflation picture, we do have some opposing forces that could drive markets. We are looking at further spread of the COVID-19 Omicron variant, which has already cascaded through the country and the world. Although this new variant seems less deadly than prior mutations, it is still filling up hospitals towards capacity, straining healthcare workers and seems to have a higher infection rate in children.
Vaccinations are certainly helping mute the effects. According to the Institute of Health Metrics and Evaluation, the omicron wave could peak as early as the first few days of February. However, as with any virus, we can expect more mutations and so should expect Covid-19 to continue to cause some economic agita looking out over the long term. As Ali Mokdad, a professor at the IMHE stated, “We are going to go through a couple more weeks that are very difficult on our hospitals, but come mid-February, March, we should be in a very good position. Covid-19 as a pandemic, in the institute’s opinion, is over, but Covid-19 as a virus will be around for a long time.”
On the geopolitical front, we have seen tensions rising after Russian military aggression along the Ukraine border. Although Russian President, Vladimir Putin, has repeatedly denied that he plans to invade Ukraine, actions speak louder than words. The actions on the border have caused the State Department to have diplomats leave the Ukrainian capital, have resulted in meetings with Joe Biden and other Western leaders, and have forced the threat of further sanctions should an invasion occur. All of this could cause a short-term flight to safety and be an opposing force to economic stability, rising global rates, etc. At the least, The Fed will need to discuss geopolitics and Covid-related economic factors during their meetings this week, as both will have implications on markets and rates.
Now, focusing on our bread and butter, the fixed income markets have certainly had an interesting January. Treasury rates have been on the rise, and we have seen yield curve flattening based on stubborn inflation and bond market participants attempting to get in front of moves by the Fed. Ultimately, the pace of rate hikes will continue to have impacts on the steepness of the curve.
Wall Street analysts seem to remain positive on the muni sector when they discuss the year ahead. On the new issue front, the trend is expected to continue with another record year of supply. Bank of America co-head of muni research, for example, said “generally we see 2022 as a very, very positive year for munis”. They expect $550 billion in new state and local debt, driven largely by public works projects.
They expect a 4%+ return in longer munis in 2022 and a flattening effect following the Treasury curve. Thus, they expect shorter maturity bonds to have more paltry total returns over the short term as this flatten happens.
With all the stimulus that we have seen, municipalities are in a good spot fiscally. With the overall economy being strong (net of COVID), federal stimulus, infrastructure funding and increasing tax bases, most expect very few bankruptcies or defaults in 2022. Additionally, with the anticipation of higher tax rates on the wealthy, there is an assumption of increasing demand for tax free municipals in general. This demand will likely keep up with or surpass new issue supply and will help to buoy the municipal markets relative to other fixed income asset classes should rates continue an upward trajectory this year.
As part of our portfolio and position monitoring, we always turn an eye to the major ratings agencies to get an overall lay of the municipal landscape and to evaluate overall market health. As seen below, upgrades continue to outpace downgrades substantially. Airports and Healthcare bonds are leading the way on upgrades since the beginning of the year.
Historically munis have had a lower Beta than other fixed income sectors, and this lower volatility is one point that has been appealing to the investor who already has a larger portfolio built and now strives for safety of principal. Interestingly, since the COVID debacle started in early 2020, munis have also shown a very different correlation to
Treasuries. The correlation coefficient has moved from 0.9 vs. Treasuries (meaning that they move closely together in lockstep) to 0.43. See below:
This correlation differential is appealing to many Advisors seeking ultimate diversification. With this in mind, Wesly Pate of Income Research & Management recently stated, “Munis are likely to retain a greater amount of their value compared to other asset classes should there be a selloff in Treasuries in 2022”. We agree with this statement wholeheartedly, and it shows up in the chart below, highlighting muni outperformance as we have seen a January 2022 Treasury selloff.
Last week, municipal bond funds and ETFs began to see sizable outflows. According to CreditInsights, this is only the fourth time where muni funds had outflows in the past year. Blackrock’s national bond ETF, ticker MUB (a traditional “benchmark” for demand in investment grade municipal markets), saw its $5 billion fund lose $310 million of assets in a week.
Interestingly, over the past couple of weeks, the phone has begun ringing with many Advisors bringing up the following questions in conversation: “I am hearing that the Fed is going to raise rates many times in 2022. Won’t interest rates begin to rise with this and bond prices go down? If rates rise, do I have risk in my induvial bond portfolios? Do I have risk in my core bond funds and ETFs as well?”.
The conversation and answers to the questions above are certainly portfolio and credit specific. We can begin by answering generally in a discussion about Net Asset Value risk inside of bond funds and ETFs, and then follow-up with a discussion about the similarities and differences in customized individual bond portfolio vs. bond funds/ETFs.
When we see significant weekly outflows from large municipal bond funds and ETFs, it makes us raise an eyebrow and evaluate whether there could be a liquidity problem for managers based on portfolio and position size. This evaluation includes us looking at some of the markets that we operate in every day to see if we can get confirmation of unfolding events. One area that we pay particular attention to is the bid side of the market. We have Advisors coming to us daily to put bonds out for bid. This can be for a variety of reasons – a client might need cash, asset allocations might change, etc. Whatever the reason, we always use the bid side of the market as a barometer and evaluation point.
We always preach to the “odd lot advantage” for the buy and hold investor. On the buy side, there is typically an advantage in buying a smaller bond lot size versus large institutional sized pieces that might have more demand. This can help an Advisor pick up handfuls of basis points for her client. However, one would think that if this is a benefit to the bond buyer, it must be a burden to the seller, right? That could be the case in typical markets when selling to the street (we can usually use these higher quality bonds internally and so can also cut into that spread). However, please check out a snapshot of a bond that we recently put out for bid:
There was a 3 million face size lot out for bid that got no bidders. The same day, there was a small, 35 face sized lot that got 3 bids. Why would this happen? Well, we have seen a recent phenomenon where during times of market stress, managers of large municipal desks tighten the reigns on their traders. They do not keep the inventory that they once did, even if hedged, and effectively won’t be allowed to bid large position sizes to take on risk.
There is a fallacy out there in the marketplace that odd lot bonds can be a disadvantage when needing liquidity. Liquidity is only as good as the bids that one can get at any time on securities that are owned in a portfolio. Thus, thinking counterintuitively, if the market falls under stress and trading desks are not taking on substantial inventory, odd lots can actually provide a liquidity advantage over larger bond lot sizes which may not even get a bid.
Last week we saw exactly this type of activity on the bid side – increasing numbers of larger sized pieces out for bid, minimal or no bidders for large pieces/bids coming back on odd lots, and some sloppiness materializing in the muni market generally.
Accompanying the charted outflows (below) and in reviewing a representative MUB price chart, we can see that some larger pieces were likely creating NAV risk.
Now let’s use our feedback loop and circle back to larger ETF and mutual fund managers. These larger funds are of size where small, odd lot positions will not even move the needle inside their gigantic portfolios. Thus, they are buyers/sellers of larger, institutional sized pieces. Now, let’s assume we get a quick market sell off, investors are fleeing from these funds/ETFs, and trading desks are told to not take on large inventory positions. The result of this scenario could be huge Net Asset Value risk and major liquidity concerns for these larger funds in periods where there are substantial weekly outflows and a small amount of bidders!
Finally, would it surprise you to know that the ten largest intermediate term municipal funds hold almost 70% of all institutional assets? If there were a need to sell a large amount of bonds for liquidity, to whom would these managers sell all these bonds to? That is a good question, especially with most desks holding substantially smaller inventory than in prior years. All of this leads to substantial NAV risk in our opinion when utilizing a fund or ETF vehicle for your municipal bond investments.
Finally, our group specializes in municipal closed end fund investing for some RIAs who are either looking for a higher level of income and/or are looking for vehicles to gain municipal exposure outside of a core individual bond ballast in portfolios. Many of these clients are OK incurring more volatility for a small amount of exposure to closed end funds.
You may be aware that, unlike ETFs and mutual funds, closed end funds trade at premiums and discounts to Net Asset Value. Premiums/Discounts can occur for a variety of reasons. However, many times these funds will have a discount widening effect in times of market stress or with rate movements, and certainly in times of flattening (as many utilize leverage). Sometimes, seeing municipal closed end fund discounts widening out quickly can be telling. Paying attention to premium/discount charts can help us to forecast when we might expect to see sloppiness in our usually calm muni trading, and they can certainly help us confirm a thesis of developing volatility in the overall muni bond markets. We were seeing some of this last week as we saw rates higher, muni fund outflows and a lack of bidders on larger pieces.
Hopefully the walk that we just completed through the muni bond land, and how certain inner workings of the auction market can lead to NAV risk in core funds/ETFs, makes sense to you as a fiduciary to your clients. It is an easy, fluid subject for us as we are working deep inside the markets every day. For the Advisor who specializes in financial planning/client interaction, it may be a little more foreign, so please do not hesitate to follow up with us regarding any questions that you may have on the subject.
To wrap things up, we will take a deeper dive into why we believe that odd lot individual bonds ladders make sense for an Advisor’s core fixed income portfolios, but do want to show you one chart as food for thought to follow up with next month.
Many Advisors ask the question as to why we would continually buy bonds if we believed that rates were going to rise. The answer lies in the consistent, defined maturities of individual bonds, and the systematic reinvestment of maturing principal back into the laddered portfolio. As rates rise, one is consistently increasing the yield expectation of the portfolio, all the while knowing what income and yield they are getting on the principal already invested. Additionally, with the consistent reinvest, one has a buffer against interest rate moves and a great sleep at night factor in knowing specifically what they are always earning in the portfolio (income and yield). With consistent income paying in, and good economic yield from odd lot sized bonds, we are typically able to create a diversified portfolio that is customized for your specific client/household needs and sidestep largescale liquidity issues that can exist in larger mutual funds or ETFs.
As always, please take time to digest this information and reach out with any questions or needs. Also, please don’t hesitate to leverage us in any capacity during your asset gathering endeavors for current or prospective clients.
Your PeachCap Fixed Income Team
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