The worst may be over for bond fund investors
John R. Mousseau
The second quarter of 2022 was another brutal one for fixed income instruments, with yields rising across the board.
The story was even worse for tax-free munis. Let’s round up the usual suspects.
The Federal Reserve
The Fed began raising short-term interest rates in response to persistent inflation numbers from March. In our view, this hike in the target federal funds rate should have started last summer, when we had already started to see the rise in the post-pandemic inflation rate.
The Fed is on the the sharpest upward movement in the target federal funds rate since 1994. The Fed’s hike, coupled with its markedly more hawkish rhetoric, has spooked all bond markets since March and throughout the second quarter. The 75 basis point rise this month should be met by another next month. At the same time, the Fed ended its quantitative easing. (Again, in our view, this ended about six months earlier than it should have.) Of course, the rise in short-term rates is being felt throughout the economy, from loans to adjustable rate to credit card financing rates and in the mortgage market.
Liquidation of bond funds
Bond fund liquidations have been severe. With the exception of the strong COVID-triggered selloff (followed by a rapid rebound), the selloffs have been the worst in recent history. Bond fund liquidations tend to feed on themselves and are often fueled by large inflows preceding outflows (as seen in 2021). Recently, we have started to see the outflows slow down (become less negative).
There is no doubt that inflation and inflation expectations have also spooked bond markets.
CPI and CPI CORE are at high levels. The Fed reversed its “transitional” characterization of inflation several months ago, and that shift went hand in hand with an acceleration in the pace of short-term rate hikes. Is there a light at the end of the tunnel? We think so. Although inflation is high, the bond market derivative inflation expectations through breakeven inflation rates are much lower.
But the markets waiting inflation is much closer to the longer-term inflation rate. Breakeven inflation, derived from the difference in yield between the real yield of a 10-year Treasury inflation-linked (TIP) note and the nominal yield of a 10-year U.S. Treasury note, fluctuates around 2.6%; and while that’s much higher than during COVID, it’s only slightly higher than a year ago. In other words, markets think the Fed should be reasonably successful in fighting inflation going forward. Although this indicator is not necessarily a better predictor of inflation than other measures, it is derived from the market. This speaks to the Fed’s success over the past 40 years in lowering long-term inflation expectations. Commodity prices have started to fall.
Inflation itself is a lagging indicator – an indicator that can stay on one trend while the economy has activated another trend. In addition to lumber, copper, and commodities in general, things like shipping rates have also started to drop. In other words, inflation may have peaked, although it is clear that food and fuel prices were pushed up by the war in Ukraine. Bond yields are now much higher than they were. Tax-exempt municipal bonds are very cheap, in our view, with yields over 4% offering taxable equivalent yields ranging from 6.3% to over 8% depending on state taxes and exemptions .
It’s certainly a different environment than we’ve been in since the summer of 2020. And it’s important to remember that these higher nominal coupon levels, when reinvested, can contribute powerfully to long-term bond returns. bond portfolios. This is not to ignore the damage suffered by the bond market. But we believe that from these levels, bonds are more attractive than they have been for a long time. We argue that the collapse of the muni market was caused not so much by the level of interest rates (indeed, 10- and 30-year Treasuries are at the yield levels they were at at the end of 2018). Rather, it was the speed of the rate hike that spooked bond fund investors.
So, as we enter the third quarter of the year, we believe we will see some reversion to the mean in bond yields, especially with tax-exempt bonds. This anticipation is based on falling commodity prices and falling housing starts, sales of old and new homes, retail sales, etc. All of these trends suggest that the sharp rise in yields seen in the first half of this year should start to moderate – with help from the usual suspects.
John R. Mousseau, CFA, is President, CEO and Director of Fixed Income at Cumberland Advisors. In this capacity, Mousseau is a portfolio manager and has overall responsibility for portfolio construction, management, analysis, trading and research for all tax-exempt and taxable bond accounts. . He has over 30 years of investment management experience and values reader feedback. Contact him at [email protected] or 941-926-6279.