July 22, 2022
As we cautioned in our Bond Outlook 2022: Rough Market Ahead it was indeed a very challenging first half of the year. We had anticipated interest rates to rise, but persistent inflationary pressures pushed rates significantly higher than expected. Russia’s war in Ukraine and Covid-related China lockdowns only exacerbated energy and food prices and created more supply chain disruptions. This combination pushed inflation figures to levels not seen in decades.
The U.S. 10-year Treasury yield moved from a 1.51% at the beginning of the year to a peak near 3.50% in early June before retracing back down towards 3.0% at quarter end. These moves exceeded our upper band forecast of 2.50% set at the beginning of the year. The move higher in interest rates was not limited to the U.S., with global sovereign bond yields higher during the first six months of the year.
Exhibit 1: Global Yields
The dramatic jump in yields contributed to negative total returns across all fixed income sectors. In fact, the Bloomberg Aggregate Bond Index delivered its worst semi-annual total return in over 40 years, down more than 10%, while the Bloomberg Municipal Bond Index was down nearly 9%.
Exhibit 2: Index Total Returns
Short-term rates, especially the 2-year Treasury note, rose more than longer-term rates leading to a flattening of the yield curve. The result was negative total returns for all Treasury maturities beyond 1 year. The Treasury yield curve between the 2- and 10-year maturities inverted during March and was a mere positive 5 basis points at the end of June.
Exhibit 3: Yield Curve Flattened
It was also a volatile time period for Treasury Inflation-Protected Securities (TIPS), which did not protect investors as much as one would hope for during this inflationary environment. The yield on 5-year TIPS hit a high of 3.73% before retracing most of their increases by the end of June, resulting in only a slightly better total return than 5-year Treasury securities (-4.7% vs. -6.6%).
Exhibit 4: 5 -Year TIPS Breakeven
Fed Gets Aggressive on Inflation
The Federal Reserve pivoted to a more aggressive monetary policy stance beginning in March. The central bank moved from purchasing securities in March to selling securities in May and began its tightening cycle with a 25-basis point increase in the federal funds rate. The pace increased at subsequent meetings with a 50-basis point hike in May and a 75-basis point hike in June for a total increase of 150 basis points during the first half of the year. The Fed has also made it clear that controlling inflation is their primary concern and has acknowledged that higher interest rates could increase the chance of a recession. In our view, the Fed will remain aggressive with a 75-basis point hike in July and may continue with that pace at its September meeting as it works to tame price pressures. We could see the Fed begin to moderate the degree of hikes by the end of the year if data suggest inflation is cooling, and as it balances the impact of its hikes on an already slowing economy.
Corporate bonds also had a difficult six months of 2022. The outlook for deteriorating corporate earnings coupled with an overall risk-off tone across all the capital markets pushed credit spreads wider (Exhibit 5). The credit spread widening on investment grade corporate bonds was not nearly as dramatic as the high yield corporate bond market, but still significant enough to result in lower total returns relative to Treasuries of similar maturities.
Exhibit 5: Credit Yields By Rating
The year-to-date supply of investment grade bonds diminished slightly compared to the same period 2021, but the supply of high yield corporate bonds plummeted with a decline of more than 75% of last year’s lofty record-setting level. Similar to the municipal bond market, the high yield corporate market was plagued by outsized outflows from retail investors, losing over $54 billion.
Exhibit 6: Municipal and High Yield Fund Flows
Municipal Bonds: Redemptions Dominate
After record-setting inflows into municipal bond funds in 2021, retail investors reversed course during the first half of 2022. Year-to-date municipal bond mutual funds and ETFs experienced massive and record-setting outflows with over $75 billion in net redemptions outpacing the previous record of $73 billion in all of 2013. The impact of outflows was particularly acute for longer-dated and lower-rated municipal bonds. Unlike the Treasury bond market, which experienced a flattening yield curve, the municipal bond yield curve remained upward sloping, as the yields on longer-dated maturities moved up with the yields on shorter-dated maturities. In fact, 30-year AAA municipal bond yields moved up more than the yield on the 30-year Treasury note and ended the reporting period at approximately the same nominal yield of 3.18%.
Exhibit 7: Municipal Bond Yields as a Percentage of Treasury Yields
Massive municipal bond fund redemptions also negatively impacted lower quality municipal bonds compared to higher quality municipal bonds. Lower quality municipal bonds tend to be less liquid than higher quality municipal bonds, and the demand for liquidity pushed credit spreads wider during the reporting period. As a result, the BBB profile of the municipal bond market materially underperformed AAA-rated securities by almost 2%. This has been the worst relative under performance of low-quality to high-quality bonds in a non-credit driven selloff.
Unlike most selloffs, this one was driven by interest rates rather than credit concerns. There are recent examples of the latter, including the Global Financial Crisis of 2008, the incorrect prediction by Meredith Whitney of massive pension-driven city defaults in 2013, the Puerto Rico default in 2016 and most recently the pandemic scare in 2020. In fact, the credit quality of municipalities, both state and local, is as strong as it has been in recent memory.
Exhibit 8: State Revenue Collections Versus Projections
Municipal bond credit is a lagging indication and as such, revenues remain above expectations (Exhibit 8). In fact, every state ended the 2021-2022 budget season with surpluses. As we mentioned in our annual Outlook, the combination of massive Federal government support and a stronger economy buoyed almost all municipal bond credits. Upgrades still significantly outnumber downgrades from the rating agencies (Exhibit 9). While this is good news for municipal bond credit quality, we know from experience that some municipalities will make mistakes. Some will inevitably spend too much of their surpluses, and not put enough into rainy day funds, while others may not fund pension liabilities beyond the bare minimum, and most disconcerting, lock themselves into higher future liabilities. Some municipalities may miss a great opportunity to be better prepared for the next downturn or crisis.
Exhibit 9: Municipal Bond Upgrades Versus Downgrades
As we noted at the start of the year, predicting the direction and magnitude of interest rate moves is a humbling process. While most of the move higher in interest rates may be behind us, we still look for volatility to remain high. Our forecast is for the 10-year Treasury note to end the year near 2.50%, with short-term interest rates slightly higher near 3.0%. The logic behind this forecast is that higher interest rates will continue to slow down the economy, which in turn will “cool off” spiking inflation domestically. We expect global yields to fall as well, with an increased likelihood of recession in Europe and the U.K. by year end. This will result in lower interest rates across the globe.
We remain upbeat about investment grade corporate bonds being able to outperform Treasury securities because the additional yield or “carry” will boost their relative total returns. We continue to favor floating rate high yield over fixed rate high yield but caution clients about being over exposed to the high yield sector, as the outlook for a weakening economy could push credit spreads even wider. Lastly, we believe that municipal bonds should stabilize as investors become less concerned about the potential for significantly higher interest rates. This should result in lower redemptions although outflows won’t completely disappear. Increased demand fueled by a more stable rate environment should be sufficient enough to offset selling pressures from year-end tax loss harvesting.
We are cautiously optimistic about fixed income in the quarters ahead as we believe the market has priced-in a significant portion of the Fed’s change in monetary policy. For investors, that means the potential for improved total returns. However, it is important to remember to not overweight the asset class, maintain a core short-to-intermediate, high-quality fixed income portfolio and diversify across strategies.