Weekly Wisdom – February 23, 2023

By Hightower Great Lakes on February 23, 2023

Opportunities in Fixed Income Markets

As is widely known, the Fed has raised their Fed Funds target rate +450 bps in less than a year. This has created an elevated and inverted yield curve.

The elevated curve reflects that markets believe interest rates will remain higher for longer, at least relative to where they were pre-pandemic, which was close to zero on the short-end.

The inversion reflects overall uncertainty that the Fed can maintain restrictive policy for an extended period of time and the market is pricing in rate cut expectations over the longer 2-10 year horizon.

Chart 1: Treasury Yield Curve Highest in 20 years for Maturities under 10 years¹

As a direct consequence of the Fed aggressively raising interest rates, equity and fixed income market performance was correlated for most of 2022. As rates go up bond prices come down, resulting in negative performance. Similarly, within equity markets, as rates go up, growth expectations slow and valuations contract, also resulting negative performance.

Fast-forward to today where inflation remains high, well above the Fed’s 2% target, and expectations are for more hikes in the near-term while also maintaining that elevated Fed Funds rate for an extended period of time. Inflation and the labor market will likely be the two biggest factors to watch in how the Fed positions itself going forward.

The 450 bps of hikes already implemented along with expectations for even more have presented a yield-rich environment, one which we haven’t seen in many years.

Market Action

For the week ending February 17, $5.5 billion flowed into bond funds worldwide, compared to only $300 million which flowed into equity funds.²

This stark contrast reflects the perceived value across fixed income markets relative to the risk that remains in equity markets as the Fed continues to implement restrictive policy. Additionally, high yields on the front end of the curve have presented an attractive alternative for anyone seeking to wait it out.

As a measure of relative value, the Moody’s corporate bond yield is 5.2%, up from 3% pre-pandemic. The S&P 500 has a forward price-to-earnings valuation at about 18x, compared to 19x pre-pandemic. Both asset classes offer opportunities and better aggregate values based on these select metrics, particularly for active managers.

Fixed income as a broad asset class, which is the focus of this piece, offers high-quality income opportunities for little risk. On a risk/reward level over the next 2+ years, investors are taking notice.

Safety

Owning fixed income securities until maturity, assuming no default, removes the risk of capital depreciation. Bonds will pay periodic interest and coupons, and then pay back the par value at maturity. This effectively removes market risk and allows investors to secure income.

Because Fed action has driven rates higher while minimally impacting credit spreads (perceived risk) thus far, investors can focus on safety and enjoy a higher yield. The fact that credit spreads remain relatively tight reflects a healthy credit environment; so far there is no indication from spreads that a severe recession or widespread default risk is coming to U.S. markets.

For reference, a 1-year Treasury bill offers a 5.04% YTM, compared to a 5.27% YTM for the Moody’s Corporate High Yield index. With an inverted yield curve in all segments of fixed income the question investors are forced to grapple with is how long they want to lock up money at current yields.

Chart 2: High Yield Spreads Tightening and Not Elevated, Relative to Historic Periods of Stress³

Investors do not need to seek risky investments to capture high yielding opportunities. Bonds can be held until maturity and rolled over into new bonds upon maturity. If the Fed continues to raise rates, investors can buy shorter-term bonds that capture the highest yields and incur less duration risk (price sensitivity), then reinvest those maturing proceeds into new, shorter-term bonds upon each maturity.

For perspective, this strategy is effective because of the inverted yield curve. In a normal yield curve environment, a common strategy employs the use of rolldown, which begins by purchasing longer-term bonds and selling as they draw closer to maturity and appreciate in price. As long as the Fed remains restrictive, these price appreciation strategies are largely ineffective, though interest income strategies remain attractive.

In addition to capturing the short-term yield opportunities, we like the diversification that can be obtained by also locking in some longer-term yields. Longer maturities have higher duration risk, which means they are more price sensitive to interest rate moves.

Rate hikes will have a negative price impact and rate cuts will have a positive price impact, and the impact of either one will in general, have greater impact on longer-term fixed rate bonds than shorter-term bonds.

However, with our view that inflation will not stay at these levels forever and with the Fed at a near-maximum hawkish stance, we like the yield-opportunity presented in longer maturities as these can be purchased and held throughout the near-term volatility.

It’s worth noting that price fluctuations only impact bondholders if they plan to trade the securities before maturity. If bonds are held until maturity, then the price fluctuations are not impactful since the bond will mature at its par value regardless.

Diversification

Diversification should always be a key consideration when investing your portfolio. This includes diversifying asset classes and exposures within asset classes. The only constant in today’s environment seems to be uncertainty.

Will inflation remain high?

Will there be a recession?

Is the consumer healthy?

We have our opinions and position our own strategies accordingly. Investors should maintain a diversified allocation to protect downside and enhance opportunities, over both the short-term and the long-term to meet their goals.

Click here to read last week’s Weekly Wisdom (2/15).

Disclosures

Investment Solutions is a group comprised of investment professionals registered with Hightower Advisors, LLC, an SEC registered investment adviser. Some investment professionals may also be registered with Hightower Securities, LLC, member FINRA and SIPC. Advisory services are offered through Hightower Advisors, LLC. Securities are offered through Hightower Securities, LLC.

This is not an offer to buy or sell securities. No investment process is free of risk, and there is no guarantee that the investment process or the investment opportunities referenced herein will be profitable. Past performance is neither indicative nor a guarantee of future results. The investment opportunities referenced herein may not be suitable for all investors.

All data or other information referenced herein is from sources believed to be reliable. Any opinions, news, research, analyses, prices, or other data or information contained in this presentation is provided as general market commentary and does not constitute investment advice. Investment Solutions and Hightower Advisors, LLC or any of its affiliates make no representations or warranties express or implied as to the accuracy or completeness of the information or for statements or errors or omissions, or results obtained from the use of this information. Investment Solutions and Hightower Advisors, LLC assume no liability for any action made or taken in reliance on or relating in any way to this information. The information is provided as of the date referenced in the document. Such data and other information are subject to change without notice.

This document was created for informational purposes only; the opinions expressed herein are solely those of the author(s) and do not represent those of Hightower Advisors, LLC, or any of its affiliates.

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¹ Source: FactSet (chart). As of February 21, 2023.

² Source: Barron’s. As of February 21, 2023.

³ Source: FactSet (chart): As of February 21, 2023.