2022 Mid-Year Fixed Income Outlook

Following sweeping volatility across the markets, Mike Sanders, Head of Madison Fixed Income provides a review of fixed income markets, and an outlook on what the rest of the year may hold, including; if the Federal Reserve can control inflation, the opportunities higher interest rates present, and how an active manager can take steps to mitigate risk.

When we entered 2022, investors were looking at a 10-year Treasury at 1.5%, expected Fed funds rate peaking in the 1.75% to 2% area, corporate bond spreads under 100 basis points over treasuries, and an overall expectation that inflation would peak sometime in 2022 and roll over and make the Fed not have to be very aggressive with respect to further rate increases.

What actually happened in 2022 was that inflation stayed stubbornly high – partially due to supply chain issues, labor shortages, as well as the Ukraine-Russia war, increasing commodity prices. The 10-year Treasury has reflected a lot of this uncertainty rising significantly, recently peaking at 3.5%. And the Fed has been pushed into a much more restrictive policy path, with interest rates expected to peak near 4% by the beginning of 2023.

Another interesting development in 2022 has been the significant flattening of the yield curve. Given the expectation of an extremely aggressive Fed policy, the difference in the two year Treasury and 10 year treasuries was at one point within 10 basis points. And that usually means that the Fed has fully guided the markets to where policy rates are going to be, and that the market is expecting many more hikes past what the market is currently pricing in.

No place to hide

Performance in the fixed income markets been challenging, given the shifting expectations in Fed policy, along with quantitative tightening and stubbornly-high inflation, there really was no place to hide in fixed income. The two-year Treasury moved over 200 basis points to almost 250 basis points year to date, the 10-year Treasury went from 1.5% to 3.5%. And because of the fund flow effect and fear of slowing economic growth, credit spreads have drifted wider. Equities have underperformed corporate bonds, but still negative throughout the fixed income markets.

A particularly volatile part of the fixed income market was the mortgage market. Early in 2022, the Fed announced that they would stop purchasing mortgages. That, coupled with the increased rate volatility, had significantly widened mortgage spreads to near 10-year highs. In addition to the wider spreads, certain segments of the mortgage market have massively underperformed because of the lower probability of pre payments by borrowers, and the Fed owns a lot of those mortgages. The odds of the Fed being able to reduce the holdings of mortgages to the level that they would like, without outright selling, have probably been reduced. That is something that we expect, but definitely has caused uncertainty in the market and the volatility.

The Fed’s path forward

Our view is that the current market expectations the of the Fed are a little too aggressive. The market has expected the Fed to be more around 4% by the first quarter of 2023. For the Fed funds rate, you know, our view is that is a little too aggressive by the market, that would be a massive amount of tightening by the Fed if you add the amount of quantitative tightening that would have occurred. So our thought is that there will be enough inflation rolling over, as well as slower economic growth to cause the Fed not to have to move rates that high, and therefore, hopefully, reduce the probability of a severe slowdown.

The biggest risk for the Fed is they can't get inflation under control. The Fed cannot control oil prices; the Fed cannot control food prices. So, the only way the Fed can reduce inflation is to try to push the economy to a much slower negative growth. And so the biggest risk the Fed has is not managing the rate moves with the forward economic picture, and over-tightening into a possibly slowing economy. And that's a very large risk. I think some of the volatility that we've seen in the markets as of late is the market trying to figure out if the Fed can pull it off.

Investors should be really following a lot of the sentiment data that has been coming out. The higher inflation has caused the consumer to sour on the forward expectations of the economy. You've seen lower CEO confidence and lower small business confidence. If if the market is able to believe that inflation will eventually roll over, we do think that the odds of the Fed having to go as hard as they, and as high as they are currently telling the market are a lot lower. And we think that would actually be better in the longer run for all asset classes.

Looking ahead: Fixed Income Outlook

The biggest headwind to fixed income is the possibility of higher interest rates from a total return perspective. This has been one of the worst years in recent memory for fixed income returns. That said, the ability to own high quality corporate bonds north of 5% is an opportunity most investors haven't seen in the past decade. So while the biggest risk to the market is that you have higher inflation, and more fund flows out of the asset class causing a more mark to market losses, our view is that it is a very good opportunity to own fixed.

Within the corporate bond sector, we still like financials. Banks have been well-regulated after the financial crisis, and if you look at reserve activity, they are reserving a little bit more against potential losses. From the activity that we've seen from the banks, there is not a lot of concern for a great deterioration. It is still an area that we like, and there is very good liquidity in that space versus other smaller industrial sectors.

Another area of the fixed income market that we think is very attractive is the front end of the Treasury curve, the expected movement by the Fed is for a lot of rate hikes for the next eight to 12 months. If you look at where you can earn yield on the front of the Treasury curve versus where you could have it sitting in a bank, it's about as big of a spread as we've seen in the last decade. Currently, the two-year Treasury is roughly around 3%, while bank deposits still pay very, very low interest rates. And so we've seen a lot of activity in that part of the market where investors have been shifting their cash holdings from a bank into short treasuries or intermediate treasuries for that additional yield pickup at a very low risk.

Actively managing fixed income risks

We are very mature in the credit cycle. And there are going to be winners and losers that you need to decide whether you're going to buy or not, and buying a broad exposure to the market. At Madison, we internally rate every corporate bond that we purchase, we're looking for stable balance sheets, good cash flows, management that balances both bond holder and shareholder activity. And so when you restrict the universe to those higher quality names, it lends itself to, you know, leaning in maybe slightly lower yielding names.

Throughout 2022, Madison's philosophy of being more conservative with both credit and duration had definitely proven their worth. Going forward, we are taking steps to improve the risk-return characteristics in the strategy if we do have a reversal in interest rates, and we are reducing the credit risk slightly in the strategies to better balance the possibility of maybe a slower economy in 2023. If you think about the yield and strategy at the moment, and what those total return prospects could be, you know, it's really never been a better time in recent memory to own fixed income.

“Madison” and/or “Madison Investments” is the unifying tradename of Madison Investment Holdings, Inc., Madison Asset Management, LLC (“MAM”), and Madison Investment Advisors, LLC (“MIA”), which also includes the Madison Scottsdale office. MAM and MIA are registered as investment advisers with the U.S. Securities and Exchange Commission. Madison Funds are distributed by MFD Distributor, LLC. MFD Distributor, LLC is registered with the U.S. Securities and Exchange Commission as a broker-dealer and is a member firm of the Financial Industry Regulatory Authority. The home office for each firm listed above is 550 Science Drive, Madison, WI 53711. Madison’s toll-free number is 800-767-0300.

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Non-deposit investment products are not federally insured, involve investment risk, may lose value and are not obligations of, or guaranteed by, any financial institution. Investment returns and principal value will fluctuate.

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Bond Spread is the difference between yields on differing debt instruments of varying maturities, credit ratings, and risk, calculated by deducting yield of one instrument from another.

Bonds are subject to certain risks including interest-rate risk, credit risk and inflation risk. As interest rates rise, the price of bonds fall. Long-term bonds are more exposed to interest-rate risk than short-term bonds.