Bond Talk: State of the Markets

Bond Talk: State of the Markets

Recently I sat with Adviser’s interim chief marketing officer and director of content, Jacque Murphy, for a Q&A on the state of the bond market. Here are highlights from the discussion.

Jacque Murphy: Let’s begin with bond performance year-to-date. What were the biggest surprises for you?

Chris Keith: To get right to the point, performance has been disappointing this year.

The Bloomberg U.S. Aggregate Bond index, which is to the taxable bond market what the S&P 500 is to the stock market, has experienced a broad-based decline and is down 13.9% for the year. It didn’t matter if you were in Treasurys, agencies, corporate bonds, securitized bonds or short- or long-maturity bonds. Bond investors were disappointed by all of them.

Note: YTD returns through 9/28/22. Sources: Bloomberg, Adviser.

The most surprising factor was how quickly the bond market turned earlier this year. Rates should have risen (and prices fallen) more than they did in 2021, but traders appeared to be in denial about inflation and what the Fed was prepared to do to combat it. Once the calendar flipped to 2022, they got the message and the big sell-off began.

We had a bit of a respite midsummer: The bond market’s 2.4% gain in July was the best single month in about three years. Unfortunately, we didn’t get to enjoy that for long—the index declined another 2.8% in August and has fallen further in September.

JM: Where does the Federal Reserve come into this? Is the Fed behind the curve when it comes to battling inflation?

CK: Let’s just say it is playing catch-up right now. The “transitory” theme is one the Fed really believed in, but one that ultimately proved wrong. The Fed and other central banks all around the world are in the same boat and playing catch-up in efforts to confront elevated inflation. As we saw from August’s consumer price index report, which showed inflation up 8.3% year-over-year, we have a long road to travel before we arrive back at the Fed’s acceptable level of around 2%.

JM: Does that mean you believe a recession is likely?

CK: To effectively tame inflation, the Fed needs to slow down economic growth, so recession does seem likely to me, but it doesn’t have to be devastating or deep here in the U.S.

Fortunately, we are starting from a position of strength in employment. And even though consumers are spending more on food-related expenses than they were a year ago, gas prices seem to have peaked. When consumers spend less on gas, they have more to spend elsewhere. We’ve also got several Fed rate hikes behind us, so inflation may be ripe for a pullback. The worst of it could be behind us.

JM: There’s a lot of talk about bonds being oversold. Do you agree? If so, where are you finding value today?

CK: This is debatable. Earlier this year bonds were oversold relative to where the fed funds rate was. And what’s attractive or cheap today may change by the time this interview goes live.

I will say this: If an investor has cash to invest but is unsure where to go, then there’s a great waiting room for them—short-term Treasury bonds. As of mid-September, three-month and six-month T-bills are yielding roughly 3.3% and 3.9%, respectively. That may not seem like much, but it’s a matter of perspective. It’s been a long time since an investor could earn 3% or better on a short U.S. government-guaranteed bond. Since the early days of the pandemic, the average yield has been 0.54% on a six-month Treasury, so today’s 3.9% level seems sky-high in comparison.

To me the bottom line is this: Short Treasurys are an attractive credit-risk-free option for investors who prefer to wait this period out but want to earn a better rate than they’ll receive sitting in a money market fund. Now they can do so without having to tie up their money for several years. And an added bonus is that Treasury bond income is tax-exempt at the state level.

JM: But what about the impact of rising rates on that six-month bond?

CK: It’s only six months until the bond matures, and you get your money back. And, if rates do rise materially higher, then you get to reinvest at those higher rates when your bond is redeemed. That’s the holy grail for bond investors—having a bond mature when rates are rising.

JM: Let me wrap this up by asking if you see any major threats ahead for the bond market?

CK: The same threat that always exists: Liquidity, which is never a problem until it’s a problem. The old saying is that liquidity is a mile wide but only an inch deep. Access to capital is the lifeblood of a functioning economy, and confidence/ability to trade that debt at a fair price is the lifeblood of the bond market. There’s got to be access to capital for bond issuers and a reasonable bid-side for bond investors who hold that debt. Wide swings in Treasury yields this year have become an obstacle for everyone.

JM: Thanks, Chris—any final thoughts?

CK: As always, we’re looking for ways to help our clients generate the income they need at the appropriate risk levels. Being a proponent of bonds during a rising-rate environment might seem to run afoul of that “don’t fight the Fed” investment rule of thumb, but my philosophy is to think longer term—the Fed’s actions today are causing bond yields to rise, and higher yields provide an enormous tailwind for fixed-income investors over time.

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