Bond alchemy: turning duration into a positive

Bottom line up top:

• Don’t expect a repeat of the first quarter’s bond market rout. Treasury yields jumped at a pace and magnitude rarely seen historically (Figure 1). This dragged down fixed income returns broadly, but punished longer-duration and higher-quality assets the most. A similar rate shock looks unlikely in the near term for a number of reasons: Much of the bad news (Fed hikes, inflation) has already been priced in, bonds tend to be resilient following selloffs and during Fed hiking periods (Figure 2), and in many cases fixed income fundamentals are good and getting better.
• Et tu, muni investors? Municipal bonds have become a poster child for areas of the market that investors have shunned, regardless of improving fundamentals. The amount of stimulus allocated to municipal governments, for example, has eradicated some budget deficits for years. Despite this good fiscal news, investors have been pulling out of muni funds to the tune of about $40 billion per month. Historically, selling out of municipals after a rate spike has been a bad idea (Figure 3).
• Value emerging from the bond market wreckage. While our taxable fixed income teams remain focused on shorter duration (especially the 3- to 5-year part of the curve) and credit sectors, potentially attractive entry points are coming into view for some longer duration assets that were among last quarter’s biggest losers. Investors with a more bearish take on the economy or wishing to bolster exposure to high-quality fixed income as a defensive measure can consider selectively adding to or staying invested in these segments.

Portfolio considerations

Unexpecting the expected. Investors aren’t used to seeing dramatic losses in their bond portfolios, particularly when equity markets are also declining sharply. We don’t foresee such simultaneous selloffs becoming the norm, but less predictable correlations could become more frequent as the Fed continues its policy normalization and liquidity conditions tighten. To address this, we suggest a combination of real assets for inflation protection and private assets, which may offer higher expected returns per unit of volatility. A strategic allocation to core bonds should also help cushion against possible growth shocks.

Giving credit its due doesn’t have to mean ignoring muni buying opportunities. In taxable markets, our teams continue to favor credit-sensitive sectors, where issuers have ample interest coverage ratios. These include floating rate loans, high yield corporates and fixed-to-floating preferred securities. In municipal markets, higher-yielding debt has outperformed investment-grade during the selloff. As a result, our muni teams see value at the long end of the municipal curve, where AAA/U.S. Treasury ratios for the 10- and 30-year segments sit at 95% and 104%, respectively — well above their historical averages.

Beyond bonds, glimmers for growth stocks. Growth stocks were also pummeled by the surge in yields. We’re expecting to see them stabilize, however, with some major technology names posting gains after strong first-quarter earnings. Growth shares moving higher in the wake of downside data surprises like the negative first quarter headline GDP print could be a sign that yields are close to peaking.

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