Quality Time in Fixed Income

Last year Johnson Financial Group moved its Downtown Milwaukee offices from the corner of Wisconsin Avenue and Water Street to Cathedral Square. The new space is modern and beautiful, with panoramic views of the city and Lake Michigan. It also happens to be across the street from my apartment, making my one-block commute the envy of the office.

My favorite thing about not having a commute is the ability to sit and relax with a cup of coffee in the morning and watch the city wake up. The massive lake is often glassy in the morning, and on sunny days it shimmers as the sun slowly rises in the sky. Taking it all in is my moment of Zen before the workday begins.

Lately those moments of tranquility are disturbed the minute I turn on the TV to check the markets. I prefer Bloomberg TV, where the tone is slightly less feverish than CNBC, but the headlines are the same: persistent inflation, rising interest rates, and falling stock and bond prices.

Experienced equity investors have been here before and understand the perils of timing the market, but fixed-income investors aren’t accustomed to this kind of volatility and may be tempted to bail on bonds. Let’s look at why you should resist that temptation and focus instead on moving up in quality within fixed income.

What’s Priced In?

Most of this year’s bond market decline can be attributed to rising Treasury yields rather than fears about corporate credit quality. Two-year Treasury yields have risen from about 0.75% at year end to about 2.50% as I type this. This comes as the market has priced in the fastest rate hiking cycle since the mid-‘90s.

Markets are betting that the Fed will raise short-term rates from 0% to 2.75% by the end of 2022 to crush inflation. This is above the so-called neutral rate, the theoretical level of interest rates which neither boosts nor constricts economic activity, meaning that the Fed is willing to dampen demand to slow the economy.

Fears of restrictive monetary policy and high input costs, as well as profit warnings from big retailers such as Target and Walmart, have economists revising down growth expectations, with some calling for a recession as early as next year. The 10-year Treasury yield, a better barometer of long-term growth and inflation expectations than the 2-year, peaked at 3.20% on May 9 and currently sits at 2.75%.

We believe that interest rate risk has been largely priced into the market and that we could be in for better bond returns as investors begin to focus on risks to growth and profits. This type of reversal has played out in previous cycles going back to 1976, with poor 3-month bond performance translating into strong 12-month returns as shown in the chart below.

What’s Not Priced In

Although not our base case, we believe recession risks are rising. We have seen these fears playing out in the equity market as highflying but unprofitable tech stocks crash to Earth while investors flock to quality dividend payers. This has happened to a lesser extent in the bond market, where we don’t believe recession risk is adequately priced into lower quality credit.

The chart below plots High Yield and Investment Grade corporate credit spreads vs the S&P 500 Index of large U.S. equities. Credit spreads are only marginally wider so far in 2022, with High yield and Investment Grade bond spreads resting near their longer-term averages. If recession risks increase, we expect these spreads to widen as they did during previous growth scares.

Time for Quality

As with the flight to dividend-paying equities, we believe the current opportunity for bond investors is to upgrade the quality of their bond portfolios by taking advantage of the highest yields since 2018.

In client portfolios, we have sought to trim exposure to below-investment-grade issuers while modestly extending the average maturity of our holdings. Diversified, high-quality intermediate-term bond portfolios now yield over 3%, while taxable-equivalent yields on municipal bonds are over 4% for investors in the highest tax brackets.

These yields may not be enough to induce the Zen-like calm of a Lake Michigan sunrise, but we believe it will lead to a smoother ride for investors navigating increasingly choppy waters.