This episode focuses on why fixed income is back on the agenda after a year of turbulence in the markets.
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René Picazo: I’m René Picazo, head of the Wealth Client Group at Allspring Global Investments, and you’re listening to On the Trading Desk®.
Today we’re discussing five reasons fixed income is back on the agenda after a year of turbulence in the markets. Joining us is George Bory, chief investment strategist for Fixed Income at Allspring Global Investments, to provide his insights on this topic. Thanks for being here, George.
George Bory: Hi, René. Thanks for having me.
René: It’s been quite a year for fixed income investors, with broad fixed income markets down 10% to 20% on a mark-to-market basis. Negative returns are not what investors signed up for and double-digit returns are definitely not what they’ve signed up for—and they haven’t seen that type of thing in decades. What’s Allspring’s view moving forward? Should investors cut and run or just lean in?
George: You certainly summarized the pain that many fixed income investors are feeling, and we certainly share their pain. But it’s not quite that simple.
Yes, bond prices are down and down quite a bit, as you point out. 10% to 20% down is not what a fixed income investor signed up for. But it’s important to remember that most of those losses are on a mark-to-market basis. The losses are only real if they’re realized, if an investor sells.
Most bonds are performing as advertised. The cash flows that were offered when the bonds were issued—they’re coming in as expected. And, so, investors are getting what they asked for.
But really what’s important is when we look forward, when we look toward what bonds are likely to do next year and the year after, the big repricing we’ve seen has meant yields are meaningfully higher. And that’s perhaps the most important aspect of a bond investor’s perspective right now.
We’re seeing a seismic shift in the fundamentals and in the technicals this year across the entire global bond landscape.
Fundamentally, inflation’s at a multi-decade high. Growth is slowing. The political alignment that has been in place for many, many years is highly fractured. Central banks are using all the tools necessary to fix inflation, but in reality, the only thing they can do is slow growth.
The Fed (Federal Reserve) couldn’t be more explicit. They’re going to raise rates. They’re going to raise rates until inflation comes down. They’re going to remain hawkish. They’re going to do everything in their power to restore price stability.
To us, that means two things. One, rates are going to stay higher for longer. Two, the probability of a recession is going up.
But in addition to that, they also are very clear that they’re reducing their balance sheet. And so, bond investors are being asked to fend for themselves. This is a major change in the way the bond market’s been functioning for the last decade or so as central banks step away from government intervention after many years of direct involvement.
So as a result, these factors have clearly driven down bond prices, but yields have moved up quite a bit.
Then perhaps the other important aspect is that the world is becoming a more bond-friendly place. That means central banks have moved decisively to try to contain inflation pressures and moderate growth. That has tended historically to benefit bond investors, but clearly, it’s a very bumpy ride.
René: When investors are seeing so much red everywhere they look, it seems, I guess they want to know when will the bleeding stop?
George: I think the reality is that bond markets are dominated by inflation. They are keenly focused on tightening policy to fight inflation. It’s with the Fed. It’s with the ECB (European Central Bank). It’s recently with the Riksbank in Sweden. The Swiss National Bank. Even the Bank of Japan is starting to pivot toward a more hawkish position.
And policymakers have very powerful tools, but they’re somewhat constrained. This is really the result of some major shifts in the macro landscape, most of which was generated coming out of the COVID-19 pandemic, combined with military aggression in Eastern Europe. Russia’s invasion of Ukraine put a fair bit of fuel on what was already a hotly burning fire.
So, the unexpected alignment of these factors in a relatively short period of time made supply chain disruption a real issue. And the demand for goods and services was surging just as supply fell. Those forces, they’re firmly in place today.
So, when we think about what policymakers are trying to do and how that’s going to affect bond prices, policymakers will get there. We’re strong believers in the fact that the tools that specifically central bank policymakers have are very, very powerful, but they work with very long lags and they’re very broad. So, they’re not a very precise tool.
But the duration bulls, the bond investors who are out there buying long-duration bonds, will they eventually have their day as monetary policy erodes economies around the world and inflation starts to moderate? It takes time.
What we’re seeing is that yield curves, if you will, are flattening. So front-end yields continue to come up. Longer-end yields are moving up, but at a much slower pace and very far out the curve. Yields are pretty firmly anchored right now, which to us is telling us that the economy is slowing as inflation is starting to peak out.
But the central bank has more work to do and that’s going to continue to put pressure on the curve to continue to flatten. You’re going to see yield-curve inversions that are probably going to be at levels that we haven’t seen since the 1980s. And that’s very uncomfortable for a lot of investors. It makes for a challenging investment environment, but those lags in policy will, we think, ultimately work. They will ultimately contain inflation and will ultimately work to the benefit of bondholders.
René: I mean, if you look today, the U.S. 10-year is at 3.5%. So, when you look at coupling that with a deeply inverted curve, that doesn’t sound like a super-friendly environment for bond investors. Would you agree?
George: Well, first off, actually, that was where bond yields were yesterday. The reality is they’re up around 3.65% today and moving higher. I think it just underscores how quickly the market is repricing this new regime.
Like I said before, policymakers are doing their best to catch up with the market. The reality is that the market is starting to catch up to those more bearish, if you will, forecasts. Inflation is high and it’s likely to stay high.
So, when we look at headline inflation at 8%, well, guess what? The market is finally now pricing in 8% going forward in terms of economic forecast. That’s really, really important as the market catches up with reality.
The other is the Fed is now solidly in restrictive territory. They’ve made it very clear that they want policy to be restrictive from an economic standpoint. 2.5% is their rough gauge as to where neutral is. We’re now at 3.25%, which is well above 2.5%, but they intend to continue to tighten policy.
Even in Chair Powell’s comments after the meeting, he said that he wanted positive, real yields at every point along the curve to create that restrictive structure in bond markets to help slow the economy. So, to us, we want positive, real yield. I, as a bond investor, and we as bond investors, we want to be able to lock in returns that beat inflation as we go through time. That’s been very, very difficult to do for the last decade, really.
But now in today’s market, you can do that, and that’s where we start to get encouraged about bond investing.
So when we look in parts of the market, say, like the very front end of the high yield market, which some people say cyclically, this isn’t the greatest time to go in that short-term yield. But at 6.5% to call it 7% all in yields for pretty high-quality companies, that to us looks very, very compelling.
Each part of the market has its own unique set of risks, but it’s really important to underscore the value of compounding your portfolio at a rate that’s above and beyond the rate of inflation. You could not do that 12 months ago. You can do that in a lot of different ways today. And when you can beat inflation, you win over time as a bond investor.
René: Well, you and I are both old enough to remember when Paul Volcker did that long, long ago. So, absolutely. Amen to that. So many of our listeners are deeply invested in the credit markets. Can corporate credit quality hold up in the face of both slowing growth and a possible recession?
George: That’s a great question, René. We know that many of our investors, and we look at our own strategies, are heavily invested in corporate credit. They’re in municipal bonds. They’re in various forms of securitized credit. All of these securities have default risk, and when growth slows, default risk goes up. We know that that’s a consequence of moving away from government debt and buying something other than government debt.
But our message is really that you can manage your way through a recession by identifying companies that have good balance sheets, that have strong and durable cash flows. And I think, perhaps most importantly, have predictable management teams. And it’s what are companies going to do in the face of pressures to protect the interests of stakeholders? These are bondholders. These are equity investors. They’re employees. They’re everyone who makes a company function. It doesn’t mean that spreads widen. It doesn’t mean that defaults won’t rise. In fact, we expect both in the coming months. But what we’re trying to do is manage around that.
An inflationary environment actually helps quite a few companies. Companies whose revenues grow faster than their cost of debt, they tend to perform very well from a credit standpoint.
So, you look in our high yield portfolios, we’re very actively invested. This isn’t a cut-and-run environment. This is pivoting your portfolio to make sure you’re aligned with the current dynamics in the economy. That means staying geared toward the companies that have pricing power. Manage your input cost as best as possible.
I think perhaps most importantly is really look at a company’s balance sheet. We’ve spent the better part of this year doing what we would call moving up in quality. That’s not just simply selling low-quality credits and buying high-quality credits. That’s too crude. It doesn’t actually protect you against anything.
We’re digging deep into the balance sheets, into the cash flow generation of these companies. So, for us, deep fundamental analysis, it becomes absolutely critical at this point in the economic cycle. We are taking a very active approach to ensure every credit in every portfolio is properly analyzed, and we’re hunkering down.
We want companies that can manage their way through this volatility. The good news is there are plenty of them out there and we want them in our portfolios.
René: Terrific to hear. So, look, we’ve discussed government debt. We discussed credit. What about municipals? How should investors be considering putting muni bonds and profiling that in their portfolio?
George: Munis are a different form of credit risk. Earlier this year, we saw a lot of individual investors sell their munis. They needed to reduce their duration in their portfolios and the only way they could do it was sell long-duration munis. That was a good short-term decision. Bond yields have gone up. Protecting capital was the right trade. But when we look at the muni market, there’s a couple of things that jump out at us.
Number one, when we look year to date, munis have meaningfully outperformed the taxable market. The broad muni market’s down about 10%, which is still challenging. But when you look at some of the taxable parts of the market, which are down 15% or even up to 20%, there’s a notable outperformance there.
But also importantly, over the last three months, in the more recent history, munis have meaningfully outperformed as both individual and institutional investors have started to move back into munis. But more than just value, munis have two additional features that make them attractive.
First is diversification. Munis have a certain amount of economic counter-cyclicality when compared to traditional taxable bonds. Clearly, the credit worthiness of a muni issuer is still dictated by the economic cycle as tax receipts and revenues ebb and flow. But there are meaningful lags between how money or revenues flow into the coffers of municipalities and states and how a company earns its profits day in and day out. And so that timing difference, that diversification can really benefit a broad portfolio of bonds. We’re seeing institutional investors take advantage of that.
Second, it’s just simply performance. We’ve done a lot of analysis on munis, how they perform in different cycles, why you should buy them, when to buy them. The reality is munis really tend to outperform taxable debt during periods of rising rates. There’s a variety of inherent inefficiencies in the muni market that work to your advantage in a rising rate environment.
And then lastly, it’s really the overall ownership structure of the market. Individual investors still make up 40% to 50% of the owners of municipal debt. Those are strong anchor tenants, if you will—the folks who buy bonds and hold on to bonds and aren’t quick to rush to sell. That provides a backstop, if you will, that maybe the taxable market doesn’t benefit.
So, when you take value, you combine it with fundamentals, and you look at that structural anchor, munis, they’re doing well. We think they’re going to continue to do well as we go into the end of this year and into next.
René: Well, George, that’s quite a wrap on the fixed income market. With the time we have left, could you quickly summarize the five reasons we believe fixed income should be back on the agenda for investors?
George: Just to be super crystal clear, what are we doing in our portfolios?
Well, number one, we’re pretty neutral duration.
Number two, as a bond investor, you want to lock in positive real yields.
Third, you want to be cautious with your credit, but we’re not going to give up on the credit trade.
Fourth, securitized bonds.
Then lastly, I mentioned munis.
So hopefully that five-pronged strategy, if you will, it presents a road map to how to navigate the market as we go into the end of this year.
René: Well, George, that sounds like a terrific road map for investors to follow. I just want to say an enormous thank you to you for being with us today and sharing these insights.
George: René, it’s always a pleasure to speak with you. And hopefully everyone on the call gets to share in these ideas and finds them useful.
René: Well, this concludes this episode of On the Trading Desk. If you would like to read more market insights and investment perspectives from Allspring Global Investments, you can find them on the firm’s website, allspringglobal.com.
To stay connected to On the Trading Desk and listen to past and future episodes of the program, you can subscribe to the podcast on Apple Podcasts, Spotify, Google Podcasts, or wherever your podcast description takes you. Until next time, I’m René Picazo and thank you for listening.
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Diversification does not ensure or guarantee better performance and cannot eliminate the risk of investment losses.
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