Making Sense of Fundamentals vs. Sentiment in the Bond Market

Over the holiday weekend, a client asked me how we manage all the information available to us when making portfolio management and investment decisions. She said there is so much data that seems to move markets, it must be confusing to sort through it all. She’s right…knowing what to pay attention to and what to ignore is a challenge for us all (and that’s true regardless of the industry you’re in). And what’s more, just which data is impactful changes over time!

Right now, the bond market provides a good case in point. As I’ll touch on below, even though interest-rate fundamentals haven’t changed much in the past two weeks, investor sentiment has shifted substantially. As always, the need is to zero in on what matters most.

Data Sources

Johnson Financial Group’s Wealth business benefits from a number of different resources for information. There are, of course, the public ones such as websites from CNBC to MarketWatch. They may provide insight into investor sentiment; however, these aren’t very useful for our purposes because most of what they share is already known.

We also pay research companies for original research that provides information regarding economic and market trends as well as analyzing the release of current information on the economy and corporate earnings. Additionally, we are able to access research from some of the largest capital markets and asset management firms, which provide their perspective on asset valuation and investment strategy.

Finally, we spend thousands of hours with hundreds of investment management firms over the course of each year. Each of these firm’s portfolio management and research teams offers insight into the market segments and companies they follow and invest in. Because we may use their investment strategies in client portfolios, we have the benefit of being able to regularly discuss their holdings and how they are being affected by markets and economic information.

Market Mosaic

Remember that the value of a stock, corporate bond, commodity, or piece of real estate is made up of any number of variables at a point in time. For a stock, this includes earnings growth, cash flow, management decisions and a company’s product competitiveness. For a commodity, it may be the cost of growing or mining it (i.e., supply), getting it to market and demand. For a piece of real estate, it is the cash flow the property generates, the location it sits in, the quality of the property and the owner’s ability to fill it with the right tenant. Most importantly, though, the value of any asset, at a point in time, is 100% investors’ perception of all these variables, and many more, which determine how valuable an asset is.

It is important to differentiate between an asset’s fundamental value and the value it has based on investors’ perspective on all other variables. It is this difference that produces a view as to whether the asset is expensive or cheap.

Low Interest Rates

Let’s take the current value of a 10-year Treasury note as an example. The interest paid by the Federal government on a 10-year Treasury note is near 1.25% today, as you can see in the chart below. This yield has fallen from 1.55% since the middle of June. As a result, the price of the note has risen (remember yields and prices move in opposite directions for bonds). Fundamentally, not much has changed in the last three weeks to alter the price of this bond. However, investor perception has changed quite a bit.

10-Year Treasury Note

Source: Macrotrends.net

Two months ago, all we heard about was the rapid pace of economic growth and the potential for a rise in inflation. The result of this sentiment was that interest rates began to move higher in anticipation of the Federal Reserve reducing its bond purchases and ultimately raising short-term interest rates. The Fed confirmed that sentiment noting for the first time that it would raise the Fed Funds rate in 2023, by 0.5 percentage points.

Now sentiment is shifting as investors’ perception of that growth trajectory change, perhaps too rapidly in our estimation. Investors seem to be thinking about (a) when the rapid recovery from the pandemic ends and we return to a more normal pace of economic growth, (b) when that might be, and (c) what if that time is sooner than we think. We’ve talked about the bottlenecks in the supply chain inhibiting growth and that stimulus checks and extra benefits will run out and reduce consumer spending. However, relative to the pre-pandemic 2% economic growth rate we were used to, we believe the recovery growth rate will remain elevated for some time.

As investors on behalf of our clients, with a long-term time horizon, we view this sentiment shift as an aberration that can be taken advantage of. We’ve been in favor of reducing our allocation to bonds given the low level of interest rates. Because prices have risen quite a bit in the last two weeks, we’re presented with another opportunity to review our bond holdings and make changes if necessary.

The fundamentals that drive interest rates haven’t changed in two weeks. Investor perceptions have and that may be something to take advantage of. We will use our paid research, capital markets and money management partner firms to evaluate the market mosaic for our bond portfolios and adjust, if necessary, to take advantage of the current environment.

ABOUT THE AUTHOR

Brian Andrew

Chief Investment Officer | Johnson Financial Group

As Chief Investment Officer, Brian Andrew leads Johnson Financial Group's investment strategy to provide consistent, actionable investment solutions for our clients.