Fixed Income Commentary – March 2022

Forgettable February


Bond yields rose in February as market expectations of Fed rate hikes gathered steam, but the outbreak of hostilities at the end of the month limited the climb. Earlier in the month, several Fed officials on the more hawkish end of the spectrum expressed the view that a 50 basis point (0.50%, or 50bp) rate hike may be warranted at the March FOMC meeting, which pushed the short end of the Treasury curve higher. In addition to higher yields on government bonds, risk spreads (the compensation in yield that investors demand for accepting various risks) moved wider on non-government bonds during the month, pushing overall bond yields higher. As a result, the total return for the broad market as measured by the Bloomberg U.S. Intermediate Aggregate Bond Index was -0.78% for February. Meanwhile, total return for the municipal sector as measured by the Bloomberg Municipal Bond Index was -0.36%, demonstrating how municipal bonds can be a diversifier during difficult times.

This recent turn of events is surely making the Fed wish they had started raising rates a long time ago, but here we are. With oil prices now rising further and the threat of more supply disruptions, particularly for commodities exported by Russia and Ukraine, inflationary pressure is likely accelerating. This means the Fed has little ability to alter its stance toward tightening monetary policy, at least not without losing substantial credibility in the process. That said, we do believe a more consensus-style move of 25 basis points is likely in March rather than the 50bp favored by some on the FOMC. Beyond that, we believe each Fed meeting this year will likely see 25 basis point rate hikes, barring a major escalation in global tension or significant disruption in financial conditions.

While it may be frustrating to find negative price changes on bonds in your portfolio, keep in mind this transition to a higher yield regime will allow both existing and future investments to earn higher yields.

Heading in to 2022, we did not believe corporate bond yield spreads would widen based on strong earnings, solid (albeit slowing) growth momentum, and a generally favorable backdrop of good behavior in many sectors of the market.  By “good behavior,” we are referring to paying down debt, avoiding debt-financed stock buybacks, and other similar gestures that signify a certain resolve by corporate management to pay attention to bondholders.  Year-to-date, spreads have slowly leaked wider due to the above-mentioned re-pricing of expected more-rapid Fed actions and now the Russian invasion.  We do not believe much further widening is likely.  If we’re right, that should bode well for prospective performance from the credit sector.  Regardless of what happens, we advise being patient with bonds since total return over longer periods of time is what matters to investors, not short-term price movements, and income earned over time can outstrip short-term price changes.

As noted above, not all sectors of the market performed poorly in February: municipal bonds were a bright spot.  Relative to a year ago, municipal bond yields are more attractive (based on ratios of municipal-to-Treasury bond yields) and credit quality is generally better than a year ago thanks to federal dollars that have flowed to the municipal sector and the solid recovery in most tax revenue streams.

What about the economy?  Recent reports paint a mostly favorable picture:

  • Robust retail sales which demonstrate that consumers remain eager to return to normal activity and are intent on spending money.
  • Both ISM surveys, Manufacturing and Services, point to continued expansion and solid momentum.
  • The stronger-than-expected nonfarm payroll report (reflecting January hiring) is expected to be followed by another strong report on March 4 thanks to diminishing Omicron cases and the removal of many pandemic-related restrictions.

The one data series that has come in weaker recently is consumer confidence, which we hold little stock in as a barometer of economic activity since it is prone to all kinds of other extraneous concerns clouding the picture.

 

As for the Russia-Ukraine conflict, cyber threats are a concern along with higher agricultural commodity prices, some higher transportation costs, and of course higher energy costs (particularly for Europe).  There is a great deal of uncertainty as this piece is being written which, in the early hours of March, is causing a flight-to-quality bid for Treasuries (sending prices up and yields lower).  Until some kind of resolution becomes apparent, we expect the conflict will dominate market developments for both equity and bonds.  News events are evolving rapidly, but at this time we do not believe any of our corporate bond client holdings have any significant exposure to Russia.

As difficult as it is to watch the unfolding crisis in Ukraine, we are encouraged by the solid unity being displayed by most other nations and the actions taken to isolate the Russian government.  The global economy does face some risks from this development as noted above, but the overall impact should be minimal and the extraordinary stimulus measures of the last couple of years are still paying dividends.

We are grateful for the continued confidence you place in all of us at Maple Capital Management.