Fixed Income Commentary – May 2022

April Showers…Bring May Flowers?


Bond yields continue to realign to the new paradigm of higher inflation and shifting monetary policy.  While lower prices for existing bond holdings may be unpleasant, unrealized losses are temporary in nature and higher yields are a very attractive development for any investment activity from this point forward: yields are the highest they’ve been since late 2018.  For the month, the total return for the broad market as represented by the Bloomberg Intermediate Aggregate U.S. Bond Index was -2.52%, while the Bloomberg Municipal Index return was -2.77%.

Readers are surely aware that higher inflation stemming from pandemic-related issues have been compounded by the Russia-Ukraine war so no need to dwell on that, although base effects on some components of the inflation data should soon result in lower year-over-year figures.  The bigger story is the shift of monetary policy.  We have written extensively on this topic as well, and on May 4th we expect to see the second rate hike from the Fed.  This time, 50bps (0.50%) is the market expectation, and that could be followed by similar moves at subsequent FOMC meetings.

Perhaps more significant will be the announcement regarding the details of the Fed’s balance sheet runoff, or quantitative tightening process, also expected on May 4th.  Since the financial markets have only experienced one prior episode of quantitative tightening (’17-’19), there simply is not much known about how the process will affect markets.  Plans from the Fed typically include flexibility to allow for added information to inform the path, but tighter financial conditions are now developing.  Ultimately, the Fed must engineer a slower pace of economic growth in order to reduce the supply and demand stresses evident in so many areas.

Economic reports in April still point to solid growth, although the GDP report for the first quarter was dragged down to a -1.4% annualized rate by lower exports, higher imports, and lower government spending.  The disappointing headline figure obscured the strong advances in business investment and consumer spending, which grew at 3.7% annualized or the most in three quarters.  Clearly, the uneven recovery from the pandemic among our trade partners continues to distort the data, but other reports corroborate the strength of the U.S. consumer.

Uncertainties due to the war in Europe are making central bank forecasts even more challenging than usual, but the unfortunate reality is that policy rates must be raised no matter what due to the inflation problem.  Of course, most of the policy rates were at or near the zero bound so they needed to be raised regardless of the inflation picture.  In most of the developed world, the recovery from the pandemic is far enough along that emergency measures simply are no longer necessary.

Bond investors must always be alert to risk since they are lenders who expect to be paid back, preferably without a lot of drama along the way.  The sudden outbreak of war has altered the balance of risks to the upside, most especially for commodity supplies and prices.  This marked change from just a few months ago explains most of the widening of risk spreads for non-government bonds.

For anyone who was turned off by the low prevailing interest rates of the last two years, it is looking more opportunistic to invest in high grade bonds.  Those living on fixed incomes who rely on interest income can enjoy more competitive yields without taking a lot of credit, duration, or structural risk.  We are finding attractive sources of income across the quality spectrum and believe the bond market is factoring in a good deal of risk.  Can bond prices continue to fall?  Yes: picking the bottom in any market is never going to be a consistent endeavor and we do not spend much time on attempting to call the bottom.  When investing for the long term, picking the bottom is not the critical element; instead, establishing the sector mix and selecting individual issuers are the two fundamental components of portfolio management that we believe will provide investors with a lucrative plan.

One last point on the investment climate: the best time to invest often follows periods of negative price performance.  When risk seems high, investing with careful consideration of the various outcomes along with a long term view will serve investors well.