Fixed Income Commentary – April 2022

Miserable March


Following the “Forgettable February” theme, “Miserable March” was not a pretty month for bond returns, but the future income component on new bond investments will be more appealing as a result. Yields rose considerably during the month — by 90 basis points (bps) on the two-year Treasury, 50bps on the ten-year note, and 29 on the thirty-year bond. Total return results for the Bloomberg Intermediate U.S. Aggregate Bond Index and the Bloomberg Municipal Bond Index were -2.51% and -3.24%, respectively.

With war now underway in Europe, the global supply chain problems are being exacerbated by a host of additional issues that threaten to complicate and extend the inflation problem. This unfortunate set of conditions has triggered a decidedly more hawkish tone from the Fed. On March 16, the Fed began a tightening campaign by increasing its policy interest rate by 25bps. Subsequent comments by Chair Powell and others are pointing to an increased likelihood that one or more of the upcoming rate hikes will be 50bps, soon to be coupled with quantitative tightening whereby the Fed will begin reducing the size of its balance sheet.

As a result of these developments, the bond market is doing a good deal of tightening for the Fed. What do we mean by this? With market yields rising by a considerable amount in a short period of time, and with corporate bond yield spreads also widening in reaction to the Russia-Ukraine war, financial conditions are tightening.

The Fed certainly did not anticipate this kind of shock to the global economy that serves to intensify the supply-side constraints generated from the pandemic. As one economic writer noted after Powell’s appearance at a conference, “the hawkish rhetoric was blatant.”

Even without the sea change brought about by Russia’s invasion of Ukraine, the Fed seems to have realized they erred in waiting to raise rates and ending quantitative easing earlier. The war has forced the Fed to attempt to gain the upper hand in the fight against inflation. By signaling his support for a 50bps move at an upcoming meeting (read: May 4), Chair Powell wants to convey how serious the Fed is about restraining inflation. Make no mistake: the steady stream of Fed speakers beating the 50bps drum is a clear signal that at least one such move is coming. The market is already fearing this tightening campaign will go too far and will end with a recession. While it may be too early to worry about such an outcome, it simply may be required to bring inflation back to the Fed’s target range after all the extraordinary events of the last two years that got us here.

As the month came to a close, the yield difference between the two-year and ten-year Treasury notes all but disappeared, at least briefly. Much is being written in the media about how a yield curve inversion has preceded every recession since 1955. We do not doubt this is a distinct possibility, but not a near-term one and not every recession is deep or prolonged. A recession does not necessarily have to be a hugely negative event, but rather a time for the economy to pause and “press the reset button” which allows demand and supply across various sectors to be realigned.

As investors embrace higher bond yields and the resulting price declines, it is perhaps constructive to recall what lower interest rates allowed for many of us: lower borrowing costs (pat yourself on the back for that 2.75% mortgage rate!) and higher real estate values (partly explained by renewed interest in real estate due to low borrowing costs). Now that yields are moving higher, any cash generated by your portfolio from coupon payments, MBS prepayments, and maturities will benefit from higher reinvestment rates.

During the month, spreads on corporate bonds continued the widening trend from February, but they began to tighten around the middle of March to end the month with positive excess returns. Municipal bonds have lagged due in part to high redemptions from mutual funds, and valuations of tax-exempts compared to Treasuries are now quite attractive. Securitized bonds, specifically Agency MBS, suffered negative excess returns in March due to duration extension from slower prepayments and poor investor sentiment since the Fed is close to announcing a plan to reduce the size of its balance sheet. Given the sheer size of its holdings and the stated desire by some Fed officials to focus on Treasuries, there is a fairly high likelihood that outright selling of MBS by the Fed will take place at some point.

 

Our closing guidance is to be patient: investments need time to deliver. We understand that declines in bond prices may be unpleasant, but the trajectory of future interest rates can surprise and change course based on new developments. Lastly, look to bonds for the income they generate rather than for price gains.