Fixed Income

The Bond Market Is Just Doing Its Job

The sell-off in the U.S. Treasury (UST) market, especially for longer-dated maturities, has created a bonanza of headlines for investors to choose from. Interestingly, many of the recent stories have been trying to find a primary culprit or reason for the increase in yields. However, the primary drivers for the rise in rates is not due to one factor, but rather a confluence of factors coming together at the same time. Instead of getting all worked up over the current and prospective state of the fixed income arena, our advice is to filter out the noise and just chalk it up to the bond market is just doing its job.

For many bond investors the yield levels for the UST 10 and 30-year maturities are coming as a bit of a sticker shock, but as we have previously noted, they are only coming back to more ‘normal’ historical readings. The convergence of good growth, sticky inflation, Fed policy uncertainty and supply considerations (Treasury and AI-related) has created an environment where the bond market had to re-price itself in order to better reflect these changing dynamics. In other words, against this shifting investment landscape, concessions need to be made in order to establish a yield level that will attract buyers. It is merely added compensation for the fixed income investor for a more challenging backdrop. This development is not new and is what historically has occurred when there are no zero interest rate policies, quantitative easing (QE), financial crises or pandemics to consider as being part of the equation.

An important aspect to this run-up in UST yields has been that it has thus far transpired in an orderly fashion. Indeed, there have been no liquidity or funding issues to elevate anxiety levels more than what has already been observed just for the increase in rates themselves. In other words, it is just the bond market being the bond market.

The UST 10-year yield has now crossed the widely debated 5% threshold, and make no mistake, one rate hike may not necessarily be the final arbiter for where longer-dated Treasury yields wind up. In fact, the aforementioned forces pushing longer-dated yields higher have not gone away, and any potential duration rallies will more than likely be short-lived.

Against this backdrop and given the track record for long duration over the last two-year period, as well as our macro-outlook and relative value analysis, we would consider holding off on the “long duration” trade with a preference for a barbell approach for fixed income portfolios, anchored by zero-duration strategies.

Fixed Income Allocation: Emerging Income Opportunity amid Continued Uncertainty

The bond market sell-off has made yields more appealing for investors with medium- and long-term horizons. Geopolitical tensions, disruptions to energy supplies and a surge in borrowing to fund artificial intelligence projects remain near-term risks. Still, current yields offer more income for the interest rate risk investors take than they have in some time.

Investment-grade corporate bonds yielded 6.04%, as represented by the Bloomberg U.S. Corporate Index as of September 30. Baa-rated corporate bonds offer 6.21% in yield-to-worst, with the 1-5 year maturity sector marking 5.75%. Broad-based high yield corporate bonds now offer over 8.35%. Contrast that with five years ago (September 30, 2021), when investment-grade corporates, Baa-rated corporates, and high-yield corporates were yielding 2.12%, 2.34%, and 4.04% respectively. While spreads to Treasuries remain tight reminiscent of the period between 2004-2007, corporate bonds remain supported by strong fundamentals and robust earnings growth.

Technology companies, particularly the largest cloud and technology providers, are issuing more bonds to fund artificial intelligence infrastructure. Investment grade corporate issuance is on track for a record year. Many of these deals are unrelated to mergers, so investors have less warning before large new issues reach the market. These companies are also borrowing for longer periods, making their bonds more sensitive to changes in interest rates. Investors holding broad investment grade portfolios may therefore have more technology exposure as in the coming months if AI issuance continues at its pace.

Markets have taken note. In credit, hyperscalers have underperformed the broader investment grade index on a spread basis, while their 10s30s curves have steepened meaningfully. This is a sign that investors are demanding more compensation for duration risk from these bonds precisely where issuance has been heaviest.

However, there are still bright spots in today's market. We are nowhere near the interest rate risk levels we saw in the year after the COVID-19 pandemic. In December 2020, the Bloomberg Investment Grade Corporate Index’s duration peaked at 8.84 years; it currently rests at 6.34 years.

We also believe comparisons with the telecom bubble of the late 1990s go too far. Heavy spending is reducing the free cash flow of today’s largest technology borrowers, and their growing debt is a concern. But they entered this spending cycle with stronger balance sheets and higher profit margins than many telecom companies had before the downturn at the turn of the century. The rapid growth of hyperscaler debt issuance hints at the continued importance of security selection in generating alpha in the coming months.

In other parts of the Fixed Income market, Municipals endured a painful third quarter with rising Treasury rates and heavy supply, including record issuance in August. The silver lining is that the sell-off has left municipal bonds with higher taxable equivalent yields and better value compared with other bond sectors. The 4.78% yield on the Bloomberg Municipal Index suggests taxable equivalent yields from 7% to 8% for affluent investors (those exposed to the higher marginal income tax brackets).

Overall, we believe the recent sell-off in Fixed Income markets has created more attractive long-term income opportunities for fixed income investors, but investors still need to navigate near-term headwinds – punitive energy costs, persistent high inflation, increasing debt supply and Geopolitics tensions.

Current Positioning: Yield Now, Pursue Later

Within fixed income, we remain confident in our current positioning, which reflects a deliberate balance between income generation and capital preservation:

• • • Duration: NEUTRAL Even though risk-free interest rates have risen sharply in the past few weeks, and we are at levels not seen in years, we maintain a neutral duration stance. We acknowledge the fact that the positioning and sentiment is extremely bearish for treasuries and a bounce back cannot be ruled out, however, our duration stance is rooted in our conviction that investors will continue to demand higher rates from borrowers due to ever increasing debt supply, persistent high inflation and strong economy. Overall, this positioning provides flexibility. We remain generally underweight Treasuries.

• • • Credit Exposure: NEUTRAL with an Income Tilt While tight valuations limit scope for further spread compression, all-in yields across both investment-grade and high-yield corporates remain attractive. Corporate fundamentals are healthy, and we continue to favor investments in quality-screened high-yield debt over longer-duration investment-grade corporate bonds.

• • • Securitized Assets: OVERWEIGHT We retain a modest overweight to securitized credit, taking advantage of the broad opportunity set with structural protections, and high-quality underlying collateral. Investments in non-agency residential mortgage-backed securities and asset-backed securities are particularly attractive.

• • • Emerging Markets Local Debt: NON-CORE POSITION Emerging market local debt remains an attractive source of income, supported by solid macroeconomic fundamentals. We continue to favor overweight positions to select Latin American countries, which feature high interest rate carry and strong fundamentals. We are carefully monitoring the situation with rising dollar and Diesel shortage and how it might impact our relative positioning between EM countries.

• • • Municipal Bonds: OVERWEIGHT Within tax-sensitive accounts, we continue to favor municipal securities. After-tax income has become more compelling while credit fundamentals across the sector remain solid.

Risks to the Outlook

Recent market developments reinforce the importance of remaining nimble. The ability to identify and respond to risks as they develop is just as important as getting the broad macro thesis right. The shifting dynamics of the Iran conflict and the reactionary efforts of the administration to counter its effects are just two facets of uncertainty investors are currently navigating.

Add in the Fed pivot to raising rates, elevated sovereign debt, AI debt expansion, and questionable seasonality impacts in economic data, there are a myriad of factors for fixed income to digest. These imbalances have a way of being absorbed until a catalyst forces a reassessment. Maintaining a diversified, income-oriented, tactically flexible posture remains the most prudent way to manage through it.