July 26, 2021 | Cameron Parkhurst
As we get into late summer, some aspects of the market have changed a bit... inflation is creeping up in lockstep with CEOs being launched into space. This new “space race”, albeit a bit comical in some regards, might keep the retail crowd’s mind on other non- market related areas. However, as institutional fixed income investors and traders, we must have our feelers out for potential areas of the market that could cause volatility for our portfolios. By laddering bonds, we are to a large extent insulated from this, but it is always worth the discussion.
The biggest space invader continues to be inflation. The Federal Reserve seems to be talking out of both sides of their mouth regarding this subject. On one hand, we hear the story of essentially downplaying risks of an ongoing inflationary environment and that it is “transitory”. Transitory means that it has a short-term effect and a slowdown could ensue in corporate earnings over the short term. Many CEOs have a differing opinion, and believe that we could see longer term effects, and prolonged inflation. On the other hand, we hear of tapering, especially regarding MBS. Ultimately this tapering effect could put pressure on MBS and yields in general prior to buyers entering the market.
Last week, Fed Chair Jerome Powell assured market participants that his crew believes that the inflationary environment remains manageable. The question our internal team often debates is the divergence between what we are seeing in various commodity prices (food, automobiles (new & used), housing, etc.), and bond market/Treasury yields.
There is also discussion from major bond players, like Jeff Gundlach of DoubleLine for example, citing that he believes the Feds definition of transitory has changed from 3 months to closer to a year. This point alone could change the market dynamic, as most fixed income managers always tout that the “crystal ball” does not extend past a short- term timeframe. It would be a game changer, if accurate.
One area that could be causing this divergence is the market being on hold with the COV- 19 delta variant showing its ease of transmission. Some of this could be overblown inside of the United States with the sheer amount of people who are now vaccinated, but we do believe that the fear trade could be holding yields down irrespective of inflation numbers, transitionary or not.
The second space invader is high yield, and then passing on to lower Investment Grade spreads. Extrapolating that out to lower investment grade yield spreads (over comparable Treasuries), it is pretty meager. As it pertains to our markets, we have a watchful eye towards inflation, but are continuing to bid short/intermediate term bonds where it makes sense for those RIAs and Family Offices who are asset allocating and building bond ladders. We believe this is a successful strategy, as we have seen that clipping coupons/generating income over time, far outweighs long term interest rate movements inside of a laddered portfolio, notwithstanding credit situations. High yield and really all spreads are super tight and are not providing much protection/value.
If one can buy an intermediate term taxable muni at +50 bps to +100 bps, why even entertain the risk of high yield? In our discussions, we have said, for the most part, we would not take that risk. Obviously, there are situations where the discussion will go in a different direction.
One other space invader, however, is recent Treasury moves and impacts on tax free muni valuations. There are always opportunities at the cusip level and in bidding bonds, however munis have not moved in lockstep with Treasuries. This has caused tax free munis as a percent of Treasuries to become expensive historically speaking. And in some cases, for marginal tax brackets has led us to advocate the buying of Taxables in non-qualified accounts. Whereas we would normally like to see an upper 20’s tax bracket of tax frees, you may see us recommend low 20% tax bracket for Taxables.
Our goal is always to keep the Advisor apprised of the market and that is the current landscape. There really is not a ton of value in IG corps or other asset classes relative to high grade taxable munis.
Getting 40% short end - 70% percent of treasuries on the long end is not great at all.
Taxable munis hold much more value here, even above 25% tax brackets.
Our stance is for those needing short bonds, we are eliminating 2023/2024 from the search in most cases and focusing on 2025-2028. For those conservative advisors, 2024-2032 makes a lot of sense, and focusing on tax bracket. Ideally, we would like to be buying out to 2036, to take advantage of steepness.
As always, if you have questions, let’s set up a quick 15 minutes to chat, or email us. Until next time... Your PeachCap Fixed Income Team.
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