Year-End Review

Our format this month takes a slightly different approach. First, we provide some brief color on what transpired in the bond market last month. Next, we offer some comments on economic reports and what they portend for the future. Lastly, we present some brief commentary on each of the broad sectors of the investment grade bond market with the goal of providing you a comprehensive overview of the market as we see it from our seats.

Bond Market Review

• Yields on short maturities (under 5 years) moved 7-10 basis points higher, while yields on longer maturities fell by 8-14 basis points. The resulting total return for the broad market as represented by the Bloomberg U.S. Intermediate Aggregate Bond Index was 0.04%.
• Corporate bonds lagged a bit during the month. Yield spreads rose in response to the yield curve flattening as well as other technical factors.
• MBS performance did not keep pace with Treasuries and valuations remain in transition as the Fed begins to taper its monthly purchases.
• Municipal bonds were the star performers in November after three months of negative returns. Investor demand was strong since the threat of higher tax rates is real, while supply remains rather tepid.

Economic Review and Outlook

On the economic front, several notable reports were released that reveal a still-intact strong recovery.

• The monthly payroll report revealed a healthy gain in jobs — 531,000 — in October, plus another 235,000 from upward revisions to the prior two months data. While this is encouraging, labor shortages remain widespread and at least 3.1 million people remain outside of the labor force compared to pre-pandemic levels.
• Inflation for October also revealed elevated levels: CPI was 0.9% month over month (m/m) and 6.2% year over year (y/y), while core CPI was 0.6% m/m and 4.6% y/y. Goods consumption remains elevated compared to pre-pandemic levels, and goods inflation is now a significant driver of inflation, mainly due to supply chain bottlenecks. In contrast, goods deflation was the norm for the last twenty years. We believe the secular aging of the population will result in goods consumption declining back to pre-pandemic levels. Combined with supply ramping back up as production rates adjust to demand, this should bring goods inflation back down over time.
• President Biden announced he would seek to reappoint Fed Chair Powell to another four-year term while elevating Governor Lael Brainard to vice chair. This outcome was largely expected by the market and demonstrates a desire for continuity at this still-fragile stage of the recovery as the new variant is now a potential threat.
• On the final day of the month, Powell appeared before Congress and clearly signaled he would entertain accelerating the pace of tapering while also mentioning again that the “transitory” characterization of inflation should be retired. He explained that rather than a period of time, transitory was meant to signify that inflation will not leave a permanent mark. These signals certainly imply a hawkish tilt to Fed policy, and we would expect nothing less given the need to preserve the Fed’s inflation-fighting credentials. It has also become politically acceptable to show more action in fighting inflation.

In terms of our outlook for 2022, it appears certain that monetary policy will begin moving toward normalization. While this means Fed rate hikes are likely, that does not automatically make negative total returns on all bonds a certainty. As the year progresses, investors will be scrutinizing every data release to try to determine how durable and robust growth and inflation will be, which in turn will help inform investors’ views on how much Fed rate tightening will occur in this cycle. As these views take form and evolve, the yield curve will shift and respond to investor views. The yield curve flattening since quarter end is evidence of how this dynamic can play out.

Given the higher inflation readings, persistence of supply chain bottlenecks, and Powell’s recent comments, we expect the Fed will accelerate the pace of tapering. Several Fed officials have already stated this preference.

One of the chief risks to the economy next year is China since Chairman Xi appears intent on taming real estate and limiting corporate autonomy even while maintaining a zero-tolerance policy for COVID. That said, risk stemming from China is a virtual staple on annual forecasts for as long as this writer can remember, and China’s resilience and ability to navigate should not be underestimated.

Bond Sector Review

Next, we offer some comments on the major sectors of the bond market to help clarify our investment actions in your portfolio. While every bond portfolio is unique due to the constraints, objectives, and risk tolerance of the individual or entity, these comments are meant to apply to a generic, unconstrained account and are in no way meant to apply to all:

• Government bonds (Treasuries and Agencies) remain unappealing unless there’s a clear need for liquidity or risk avoidance, so we are not likely to allocate funds to this sector.
• MBS (mortgage-backed securities) also remain unappealing for new investment. The Fed is only just beginning to reduce the pace of open market purchases of MBS, but they will continue to buy through early to mid-2022. Their buying, on top of strong demand from the banking industry, has distorted market pricing and we will wait for better value to emerge. While we favor diversification across the sectors as a general rule, unusual market conditions can at times preclude us from investing in all sectors due to rich valuations or poor fundamentals.
• Corporate bonds remain appealing for taxable accounts since earnings have recovered nicely, debt reduction is proceeding across many companies and industries, and demand remains strong from a wide range of investor types. Improving credit metrics and firm demand from investors are two strong factors that are hard to overcome, so we remain sanguine on the credit sector for 2022. As always, there are certain sectors we favor over others, and security selection within each sector remains paramount.
• Municipal bonds are attractive based on improving fundamentals, but each jurisdiction must be evaluated on its own merits and only certain maturities offer good value. Following substantial fiscal assistance from the federal government, many state and local governments are enjoying high reserve balances, growing tax receipts, and favorable budget performance. Strong economic activity is expected to continue into next year and should enable many issuers in this large, diverse sector to further improve their financial profile, even the lowest-rated states such as Illinois and New Jersey.
• Preferred stock remains an attractive source of higher yields compared to all of the above. While many issues offer inadequate yield in our view, there are several that offer respectable yield with decent call protection, meaning the issue will not be called by the issuer for at least several years. We believe a group of these issues deserves a place in client portfolios albeit with a disciplined approach since they do entail higher risk, hence the higher reward.

While these thoughts on relative value across the sectors are brief, we hope they help you better understand market conditions as well as your own portfolio. Should you wish to learn more about anything in this month’s Commentary, give us a call or drop us a line.

We wish all our readers a holiday season filled with joy, laughter, and good cheer and may all your yield dreams come true.

Important Disclosures

Maple Capital Management, Inc. (MCM) is an independent SEC Registered Investment Advisor with offices in Montpelier, Vermont and Atlanta, Georgia.

This commentary reflects the views of MCM and should not be considered to be investment or financial advice. MCM does not warranty these views and will not update this communication after the date of publication. Any mention of specific securities is done for illustrative purposes and the securities mentioned may or may not be held in client accounts. No assumption or assurance should be taken that securities mentioned will be safe or profitable investments.

For further information, please contact Steven Killoran at 1-802-229-2838 or at [email protected]. For further information about Maple Capital, including a copy of our informational brochure, please visit our website at www.maplecapital.com.

Index Definitions

The Bloomberg US Aggregate Bond Index is a broad-based flagship benchmark that measures the investment grade, US dollar-denominated, fixed-rate taxable bond market. The index includes Treasuries, government-related and corporate securities, MBS (agency fixed-rate pass-throughs), ABS and CMBS (agency and non-agency).

The Bloomberg Intermediate US Aggregate Bond Index is a broad-based flagship benchmark that measures the investment grade, US dollar-denominated, fixed-rate taxable bond market with less than 10 years to maturity. The securitized sector is wholly inluded. The index includes Treasuries, government-related and corporate securities, MBS, ABS and CMBS..

The Bloomberg US Treasury Index measures US dollar-denominated, fixed-rate, nominal debt issued by the US Treasury. Treasury bills are excluded by the maturity constraint, but are part of a separate Short Treasury Index. STRIPS are excluded from the index because their inclusion would result in double-counting.

The Bloomberg US Credit Index measures the investment grade, US dollar-denominated, fixed-rate, taxable corporate and government related bond markets. It is composed of the US Corporate Index and a non-corporate component that includes foreign agencies, sovereigns, supranationals and local authorities.

The Bloomberg US Mortgage Backed Securities (MBS) Index tracks fixed-rate agency mortgage backed pass-through securities guaranteed by Ginnie Mae (GNMA), Fannie Mae (FNMA), and Freddie Mac (FHLMC). The index is constructed by grouping individual TBA-deliverable MBS pools into aggregates or generics based on program, coupon and vintage.

The Bloomberg US Corporate High Yield Bond Index measures the USD-denominated, high yield, fixed-rate corporate bond market. Securities are classified as high yield if the middle rating of Moody’s, Fitch and S&P is Ba1/BB+/BB+ or below. Bonds from issuers with an emerging markets country of risk, based on Bloomberg EM country definition, are excluded.

The Bloomberg U.S. Municipal Index covers the USD-denominated long-term tax exempt bond market. The index has four main sectors: state and local general obligation bonds, revenue bonds, insured bonds and prerefunded bonds.