Yield Alternatives to Equity Emerge

Sticky inflation, a hawkish Federal Reserve Open Market Committee (Fed), slowing growth, an outsized dollar, and global conflict. Ten months into 2022 and the markets continue to strain under growing economic slackening. Bond prices are touching historic lows一due to the Fed’s aggressive rate hikes一and the U.S. equity markets are seemingly stuck in bear market territory. It’s the first time since 1994 that both markets are getting pounded simultaneously. 

The activity in the bond markets is particularly notable. This is the first time in decades losses have breached 10%一U.S. Treasuries haven’t been this low since the 18th century. And while painful for existing fixed income investors, there may be a glint of a silver lining for those searching for yield: TINA, a commonly used acronym in the investment community for “There Is No Alternative (to equities),” may no longer hold water. 

The Fed’s campaign to tame a recalcitrant inflation rate一with three consecutive 0.75% hikes most recently一has boosted bond yields in kind and then some. Yields are soaring 250 basis points (2.50%) or more throughout the curve, providing investors with potentially interesting opportunities in both the investment grade (IG) and high yield (HY) markets, though not without risk.

Let’s take a closer look at these potential opportunities.

Fed Actions to Tame Inflation 

Though initially slow off the mark, the Fed has spent 2022 increasing its benchmark Fed Funds level in an attempt to rein in surging inflation rates. As of September, the central bank terminal rate grew to 3.00% to 3.25%, up from 0% to 0.25% at the start of the year. 

Still, the most recent annual Consumer Price Index for All Urban Consumers (not seasonally adjusted) (“headline inflation” or “CPI”) remains above 8%, and annual core inflation (CPI less selected food and energy categories) is at a high of 6.6%. In short, inflation continues to linger at uncomfortable levels, though the CPI has moved off its earlier summer summit thanks to reductions in selected energy categories.

Thus, current expectations suggest that while the Fed is unlikely to take its foot off the brake before inflation falls closer to earth, it may begin to ease up from its most aggressive rate hikes by year-end. This is expected to align with a current Fed Funds target rate of around 4.4% by 2022 year-end or possibly as high as 4.85% by May 2023.

The Yield Curve Impact 

As mentioned, this has impacted the yield curve, increasing yields throughout, including to last week's record highs. As of Wednesday, October 26, 2022, yields tightened slightly, with the U.S. Generic Government 2-year yield hitting 4.403% and the 10-year yield at 4.002%.

New Opportunities in Investment Grade & High Yield Bonds

Similar boosts in yield are seen in IG and HY bonds with spreads of 300 basis points to 400 basis points (3.0% to 4.0%) or more since the start of the year. In the two graphs below一the first for IG and second for HY一the higher line illustrates current levels across the yield curve relative to the lower line, where yields were as of 12/31/21. The yield difference is also shown under each line graph in a bar chart format. 

Increases have also been more significant in the early maturities, pushing the curve closer to inversion (already occurring mid-curve) and recessionary signaling in these areas.

In addition, the Fed’s action next week, expected to be a fourth consecutive 0.75% rate hike, is already priced into current levels, potentially providing a little room for gains, at least for now.

The Bigger Economic Picture & Potential Risks 

Indeed, most of the rise in yields has resulted from the Fed’s interest rate hikes rather than credit deterioration. 

But while the U.S. economy remains in a modestly expansionary phase, recent declines in the Institute for Supply Management (ISM) Manufacturing PMI (PMI), a proxy for broad economic activity, suggest a recession may be forthcoming. The index has (mostly) been on a steady decline from a high near 65 in March 2021, though remains in expansionary territory for now.

Furthermore, year-on-year real U.S. GDP growth has declined from 5.72% (2Q2021) to 1.8% for 2Q2022. Consensus (and alternative) estimates show additional deceleration through the next four quarters with negative growth in 4Q2023.

If the economy were to move into a recession, we could expect credit spreads to widen, with detrimental impacts to existing bond portfolios, especially in HY holdings. Due to the current demand for yield, spreads remain relatively tight but with significant potential for deterioration under the ‘right’ conditions.

Potential Mitigating Factors 

Other variables could play a role in mitigating the impact of a recession-driven credit crisis. As is customary, if a recession emerged, a flight to quality could prop up bond prices, at least in the government and IG markets. 

In addition, in the wake of lower, or no growth, the Fed would be expected一at some point一to pivot away from its hawkish posture一even cut rates, thus eliciting a decline in yields and boost in prices across the credit spectrum.

Where We Stand 

For now, we remain vigilant in an increasingly dynamic economic and market environment. As always, we let the data do the talking and fully inform our approach to seeking out risk-adjusted opportunities on the upside, protecting on the downside, and positioning our portfolios accordingly.