So Long TINA, Hello PATTY: Baird Advisors Shares Bond Market Outlook
KOHLER, Wis., September 12, 2022 – For the 22ND year, Baird Advisors held its Institutional Investors Conference in Kohler, Wis.
Attendees first heard an assessment of the geopolitical landscape from global national security expert Anja Manuel, who touched on numerous global hotspots including Ukraine and Taiwan. She was followed by economist Paul McCulley, who explored the fundamental tensions between democracy and capitalism and how it played out during the unprecedented challenges brought by a global pandemic.
Baird Advisors Co-CIO Warren Pierson followed Manuel and McCulley and took a few moments to reflect on the state of Baird’s fixed-income asset management business; highlighted a number of awards, including Morningstar’s #1 Fund Family Award and Outstanding Portfolio Manager for Founder Co-CIO Mary Ellen Stanek; and finally, provided the firm’s annual market assessment and investment outlook.
Pierson described what he called “pretty much the worst bond market ever” in 2022 and acknowledged that as interest rates reset to much higher levels, Baird’s taxable and municipal funds experienced declines along with the rest of the fixed income markets. But he also pointed to the silver lining of higher rates--a market that finally has some room to run. Pierson said the era of “TINA”—short for “there is no alternative” and describing a phenomenon where bond yields were so low that many investors felt they had no choice but to invest in stocks, even at stretched valuations—has given way to a market where they can “pay attention to the yield(s).” Or “PATTY,” for short.
Following are highlights of Pierson’s remarks:
The Fed may slowly be gaining the upper hand
Economic historians will mark 2022 as the year the Federal Reserve began hiking interest rates in earnest, shrugging off both the notion that inflation was transitory and concerns that an overly aggressive monetary policy stance could derail an economy still convalescing from COVID. Most recently the central bank raised the fed funds rate by 0.75% at its July 2022 meeting and Fed watchers are widely expecting at least another 0.75% hike later this month. The market is pricing in a fed funds rate of more than 3.75% by the end of the year. (Critics say the Fed was late to recognize the severity of the inflation threat but, in fairness, the market was no more prescient; at the beginning of 2022 it was predicting fed funds would stand at 0.82% by year end.)
As a result of the Fed’s tightening, bond yields have climbed sharply. The rise is especially pronounced in short-term yields, resulting in a flat yield curve that is inverted in spots, with short-term rates higher than long-term rates.
An inverted yield curve historically signals that a recession may be imminent, and the jury is still out on whether the U.S. economy is already in recession or about to enter one. But when rates are higher on the short end than the long end of the yield curve, it also signals that the market believes inflation will soon have run its course. Other datapoints support that argument:
- Money supply growth is projected at 1% by mid-2023, down from nearly 6.5% at the beginning of the year
- Central banks are curtailing “quantitative easing,” their financial asset purchase programs that were restarted during the pandemic
- Some of the big contributors to inflation—consumer disposable income, rising rents and gas prices—have softened in recent months
All these factors--coupled with secular inflation mitigation trends like the relentless implementation of cost-saving technology and a population that is getting older and is on the verge of posting negative growth for the first time since the Census Bureau began tracking it in 1900—suggest that U.S. inflation may temper over the next several quarters. (It should be noted that Europe, where energy prices have skyrocketed due to supply disruptions from Russia’s war on Ukraine, may be a very different story.)
As it looks to finesse a soft landing for the economy, the Fed is likely to pay close attention to a tight labor market, where there are currently two jobs available for every unemployed American versus the long-term average of about 0.75 jobs, for additional proof inflationary pressures are subsiding.
From a TINA to a PATTY mindset
It has been painful for bond investors, but the interest rate reset to higher levels, which coincided with a widening of credit spreads, promises new opportunities for fixed income investors.
With the benchmark 10-year Treasury yielding about 1.25% a year ago, investors could be forgiven for concluding that “there is no alternative” to expensive equities. But with the 10-year now paying 3.2%, and the opportunity to boost returns even further by selectively taking on credit risk, investors evaluating their options on a risk-adjusted basis should find it worthwhile to pay attention to yields and reconsider bonds.
A closer look at credit
The 1.4% spread over comparable Treasuries paid by investment-grade corporate bond issuers is nearly half a percent wider than a year ago. While that reflects investor concerns over the potential impact of a slowing economy on corporate borrowers, it isn’t an alarming increase that would indicate major problems in the credit markets.
To be sure, corporate credit fundamentals may soften somewhat in a recession/near recession scenario, but high-quality U.S. companies were sorely tested by the pandemic induced shutdown of the economy and they generally tightened their belts and emerged with their balance sheets in good shape or, alternatively, fell into the arms of a healthy acquirer. Gross revenue, earnings, free cash flow and cash balances all now stand at or near highs for the cycle.
The below investment grade floating rate corporate loan market may be a different story as issuers there are confronted with increased borrowing costs, even as a cooling economy potentially hurts their bottom line.
As always, rigorous credit research is paramount in any sector of corporate credit. But with strong fundamentals, the opportunity set in investment grade corporate bonds looks attractive going forward.
Similarly, the opportunity set in municipal bonds has improved markedly. At the beginning of 2022, the average five-year muni was yielding less than half as much as a five-year Treasury bond, but by September the yield had climbed to nearly 70% that of a comparable Treasury.
On a portfolio basis, an investor in a high tax bracket can now achieve a taxable equivalent yield of about 5.5%--not bad for a retiree who has recently felt the only place to go for a competitive return was the overbought stock market.
The big picture
As interest rates normalize after spending the better part of the last decade near zero, compelling opportunities are beginning to emerge in fixed income markets. With the economy resetting from a global pandemic and the Fed wrapping up its pitch battle with inflation (while simultaneously unwinding its own massive balance sheet), there will no doubt be additional volatility along the way. But investors who do their homework and pay attention to yields may find PATTY to be an agreeable companion going forward.
About Baird Funds
Baird Funds is a no-load mutual fund family with more than $100 billion in assets as of August 31, 2021. The Baird Funds offer proven track records and a variety of portfolios spanning fixed income and equity asset classes. The ten bond funds and six stock funds feature competitive fees and are managed with a careful focus on risk control. For more information, visit www.bairdfunds.com.
Putting clients first since 1919, Baird is an employee-owned, international wealth management, asset management, investment banking/capital markets, and private equity firm with offices in the United States, Europe and Asia. Baird has approximately 4,600 associates serving the needs of individual, corporate, institutional and municipal clients and more than $415 billion in client assets as of Dec. 31, 2021. Committed to being a great workplace, Baird ranked No. 27 on the 2022 Fortune 100 Best Companies to Work For® list – its 19th consecutive year on the list. Baird is the marketing name of Baird Financial Group. Baird’s principal operating subsidiaries are Robert W. Baird & Co. Incorporated and Baird Trust Company in the United States and Robert W. Baird Group Ltd. in Europe. Baird also has an operating subsidiary in Asia supporting Baird’s investment banking and private equity operations. For more information, please visit Baird’s website at www.rwbaird.com.
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