January 19, 2023 | Cameron Parkhurst
Happy New Year!
We are excited to see the calendar turn over and bring a clean slate to the forefront. 2022 was certainly a historically brutal year for bond holders. As bad as it was, the bulk of our portfolios held their own on a relative basis in that they were dominated by munis. From where yields are today, we are excited about the prospects for what we might see in 2023. With the theme of this missive being “No Pain…No Gain”, we want to look back quickly into 2022, then importantly focus on opportunities that we see ahead for 2023 and beyond.
Strolling down memory lane, in 2022 we were not whistling a tune and having to wipe a smile off our faces. It was a historically intense bond market sell-off…one that we have not seen before in any of our careers.
To combat inflation rearing its head, global central banks were forced to dramatically raise rates. This was the impetus for sharp, upward momentum in yields that had not been chronicled before. Global bond Indexes were down -16%, US Taxable Bond Aggregate -13%, and even TIPS down -12%. Munis were down -8.5%.
One of the most telling tables that we saw, highlighting the strength of the sell off, is below. It puts yearly real return (net of inflation) performance numbers into a bell curve style framework. We can all see where 2022 fell:
Going back through 1926, last year’s real return is literally on the far-left tail of this table at greater than -20%. While that number is almost unbelievable, further examination of the table and the chart below helps to give us some great historical insight into what could happen this year. If one looks at the major drawdown eras, and then examines the years after the negative performance, history has pointed to consistent, strong rebounds for the bond market. We will go into more detail about our 2023 outlook shortly, but this is one reason why we have excitement for the year ahead.
The Fed was certainly taking decisive action in 2022, hiking rates at the fastest pace that we have seen.
To combat the rampant inflation caused by years of excessive “free” money being injected into the system, the Fed was essentially forced to take this action. The ramp up in Fed Funds is just now beginning to have impact, with inflation starting to roll over:
The concern, however, is that the aggressive Fed action to combat inflation will ultimately cause an economic slowdown. We were correct in discussing that inflation was not transitory in early 2022. We had also been an early bird to discuss this idea of future recession. Today, we continue to sit firmly in the camp of believing that we will see a recession later in 2023 or early 2024. As seen below, many others are now sharing that thought.
If our hypothesis turns out to be correct, this could have major impacts for markets, both fixed income and equity.
While 2022 proved tough for fixed income investors, we are now sitting on quite a bit of opportunity. For reference, check out bond yields that one saw as 2022 began, relative to the end of the year:
With rates having risen so much, the income component of fixed income came back into the equation towards the end of 2022. The premium structure has largely now been taken out of the market. Even 4% and 5% coupon bonds are now trading closer to par. New issues will have substantially higher coupons in today’s market. Investors are getting paid significantly more to hold bonds again. This is a very important variable, especially for those using financial planning models. The increased coupon income can be very protective over time for the bond investor. Additionally, bond yields now sit well above equity dividend yields. This is an important variable that dramatically shifted in 2022 and is important to investors deciding whether to invest in dividend paying stocks or to buy bonds to generate income.
As we have said previously, we are optimistic about what the bond markets could bring for 2023. History does show that we usually get a strong snapback after largescale drawdown years.
The Fed is seemingly closer to the final innings of their rate hiking campaign, and the probability of recession risk is high. With the anticipation of a pending slowdown, if we had to guess whether Treasury bonds would be higher or lower in yield than today, we would put our chips on a lower level by the end of 2023.
Amid the uncertainty, we are currently staring at a well-inverted Treasury yield curve. This is a strong recessionary indicator. See the movement/inversion on the front end since June 2022 below per Bloomberg:
While the Treasury curve is inverted, the muni curve continues to be close to flat when comparing 1-Year and 10-Year tax exempt bonds, but for the most part has a positive slope. The muni curve rarely inverts to the same depth relative to the Treasury curve but has historically flattened significantly in times before recession.
If we do believe that we are in the 8th inning of the Fed campaign, and that we will see a recession, there are many things to consider. If the economy slows down dramatically, we expect a flight to safety and rates generally dropping. The chart below illustrates that, historically, rates top out before the Fed has completed their rate rising campaign.
A second point is that we typically see an ebbing of bond fund outflows just after rates peak and begin to come back down a bit. We saw this change in December 2022. Historically, the return of inflows can be seen as a bit of an all-clear sign to investors who may have missed the top in rates.
With the assumption that we have an impending slowdown on our hands, we would favor a high-quality approach, and not be scared away from owning some duration. Some Advisors that we talk to have a current short-term bias, positioning a heavy amount of bond assets on the front, inverted area of the curve. This strategy is implicitly making a bet that short-term rates will stay high over some time period. While we believe that there is good current opportunity on that front end, there is also future reinvestment risk. This is a very important consideration in one’s financial planning.
If we again assume a flight to safety, and lower rates with the economy faltering, our goal is to be positioned with high quality bonds across the curve. The bias would continue to be intermediate term bonds, with some exposure both short and long. The short-term bonds will be systematically reinvested at maturity, back into the portfolio. The high-quality bonds with duration will exhibit a greater magnitude of price appreciation if we do get rates moving down and prices up. This is a very different approach than tying up all fixed income assets in short-term bonds and having to potentially reinvest a bulk of one’s fixed income allocation as rates have dropped. At some point, as things turn around economically, we would expect the curve inversion to assume a positive slope. As inversions are historically unstable and short-lived, the front end of the curve may not offer as attractive yields throughout 2023.
Today, our primary focus is on a high-quality approach with slightly above benchmark duration. We are also advocating that Advisors put cash to work in today’s market. In seeing meaningfully higher absolute yields, we think that this makes all the sense in the world. Additionally, we believe that we will see today’s positive equity/fixed income correlation dissolve and for bonds to again resume their role as a diversifier against equity volatility. With a recession probable, we would expect equity markets to be under pressure, and high-quality fixed income to be positive and offsetting to equities towards the end of 2023.
So…what does this mean for portfolio allocations? To us it means putting some cash to work at current yield levels. It means a focus on high quality. It means not to fear having some duration to accompany short-term bond exposure.
For high quality taxable bond portfolios, sub-asset class selection is entirely up to relative value analysis. Our focus will continue to lie with A to AAA taxable municipal bonds. If we can find insurance, various state aid programs, Treasury backing, or other support, then all the better. The higher the quality, the better, as we aim to take a protective stance with recession on the horizon.
For taxable allocations, we also continue to see value in select corporate names and specific MBS to accompany taxable munis. Occasionally we will utilize secondary market bank CDs, but they do not offer as much yield spread today as in years’ past. Treasuries are only being used for clients needing ultimate liquidity.
For those requiring higher income, the focus will be on higher coupon individual bonds. As we have previously stated, it’s much easier to find 5%+ bonds these days with very little premium structure. We are oftentimes utilizing the bid side of the market to provide price yield advantages. Many clients are seeing that the bid side of individual bonds is providing yields well above that of bond fund and ETF dividend yields. This is an important consideration when making decisions on which vehicles to use in order to generate income.
For those interested in income and who are OK in taking a bit of credit risk, certain preferreds and closed end funds can make sense. We are buying some names/tickers but are cautious here not to take on undue credit or volatility risk.
For clients in higher tax brackets, tax exempt munis obviously rule the day. Munis historically are a higher quality sub-asset class than most other non-Treasury products. The goal is to generate solid tax-exempt income and to have a nice ballast in the form of high credit quality to withstand a recession. See the chart below as a reminder. It shows the ultra-high quality that munis bring to portfolios:
One can easily see that munis have historically delivered a significantly higher credit quality than that of comparable corporates. This is one major reason why we consistently favor munis, both taxable and tax exempt.
With all of the above in mind, we feel that this is a great time to be having conversations with both current and prospective clients who need fixed income exposure. Last year was certainly quite a ride, but we strongly feel that the pain point is over…and that the gain point is upon us.
January is always a great time to conduct global, household, and individual client portfolio reviews. Feel free to leverage our staff to help with any analytics, credit scrubs, or portfolio reviews for you. This is a great value that we offer, and one that frankly gets underutilized by many RIAs. There is no cost involved in the service, and most Advisors come away from analysis projects with many good points to consider, present to their clients, etc. We are always here to answer any questions that you have, to assist in your client communications, and to allow you to better manage all facets of your fixed income allocations.
Thanks,
Your PeachCap Fixed Income Team
The above summary of statistics/prices/quotes has been obtained from sources believed to be reliable but is not necessarily complete and cannot be guaranteed. The information and opinions herein are for general information and illustrative use only. This data is not meant to replace Adviser's portfolio management/performance reporting systems. Please consult Adviser performance reports for actual performance data. Such information and opinions are subject to change without notice, are for general information only and are not intended as an offer or solicitation with respect to the purchase or sale of any security or as personalized investment advice. Past performance is no guarantee of future results. Market risk is a consideration if sold prior to maturity. May lose value. Not insured by any federal agency. Subject to availability and price change. Securities offered through PeachCap Securities, Inc., member FINRA, SIPC, MSRB registered.