Fixed Income Perspectives for the First Quarter of 2022
Financial markets experienced one of the most volatile periods in years during the first quarter of 2022, even when compared to the dramatic moves as the Covid-19 shutdown unfolded. Spanning equity, commodity, and bond markets, investors found few places to hide. However, after experiencing this rapid repricing, there are reasons to be optimistic going forward. Much of the volatility experienced in recent months arose from a realization that the Federal Reserve’s (Fed) massive financial stimulus is likely to end sooner than expected. With inflation remaining stubbornly elevated, the Fed raised its own projections for rate increases and balance sheet reduction. Investors, taken by surprise, reacted to this more aggressive approach to policy normalization by rapidly repositioning across financial markets. In the bond market, this repricing of expectations pushed yields higher, flattening the yield curve, and leading to one of the most difficult quarters in bond market history.
The Fed has left little doubt as to the path of monetary policy for the foreseeable future. As expected, the Fed increased the Federal Funds Rate by 25 basis points (bps) in March and indicated a much more aggressive path for monetary policy than just a quarter ago. The prospect of rising rates, stubborn inflation measures, and the Ukraine conflict fueled this increase in volatility across markets.
Could the Bond Market be Helping the Fed?
As difficult as the quarter was for bond investors, it’s likely that higher yields could aid the Fed in combating its inflationary concerns. Restrictive monetary conditions should impact aggregate demand and assist in cooling price pressures while supply constraints ease naturally over time. During the March Fed meeting, updated projections were released indicating a more aggressive path for monetary policy. Median estimates for the Fed Funds Rate in December 2022 and 2023 rose to 1.875% and 2.75%, up from 0.875% and 1.625% last quarter.
Interestingly, the Fed’s own long-term neutral rate remains unchanged at approximately 2.375%. The bond market expressed its view by discounting a faster path than the Fed’s forecast, pricing in a 2.375% Fed Funds Rate at the end of 2022 and over 3% by 2023, well past the neutral rate. For their part, the Fed has publicly reiterated its desire to regain control of its Congressional mandate, full employment with stable prices, by employing a patient and data-driven monetary policy normalization. The bond market, ever skeptical, has rekindled its vigilante nature and done some advance legwork for the Fed.
Spreads softer again
The cracks that formed in the second half of 2021 expanded in the first quarter, as corporate bond spreads, as measured by the Bloomberg U.S. Corporate Bond Index, widened by 24 bps to 116 bps vs Treasuries, bringing the total return to -7.69% for the quarter. High yield corporate bonds didn’t fare any better with the Bloomberg U.S. High Yield Index widening by 42 bps. Corporate bond spreads were as high as 144 bps in March before moving lower into month-end. There was no single event that was the cause of widening spreads. Issuance was at $472 billion only slightly ahead of the $454 billion issued in the first quarter of 2021. Corporate balance sheets remain strong but there is growing concern about leverage increasing in the future through share repurchases and mergers. The negative total returns have impacted the flow of funds into the asset class which has also pressured spreads. A normal source of stability in domestic bond markets has been foreign buyers, however, with central banks having significantly divergent policy paths, this normal reliable source of buying has been greatly reduced.
Cloudy outlook for mortgage-backed securities
The mortgage-backed security (MBS) market was not immune to the spread volatility experienced during the first quarter as MBS underperformed similar duration Treasuries with the Bloomberg U.S. MBS Fixed Rate Index returning -4.97%. The significant back-up in interest rates significantly increased the rate sensitivity of MBS. Currently, over 75% of the Agency MBS market is trading below par which is the highest level since 2005. Additionally, the Fed is expected to announce the start of quantitative tightening in May thereby removing the largest, non-economic buyer of the asset class. The private sector will have to absorb the increase in MBS issuance which could continue to pressure spreads.
Volatility and the Silver Lining
There’s no other way to say it, the first quarter was a difficult one for all investors. Seldom have we seen such a rapid and powerful revaluation across nearly all market sectors. The first quarter of 2022 underscores the need for a consistent, disciplined, and risk-conscious approach to investing. The upward move in rates has restored market yield to fixed income investors after a prolonged period of lower-than-average Treasury yields. Alongside this rise in Treasury yields, widening spreads have brought corporate bond valuations back to more reasonable levels. With these more reasonable valuations, we view present market conditions as providing more opportunities than we’ve seen in several quarters. While we have begun to take advantage of improved valuations in recent weeks, we view the coming months as likely to present more opportunities as the path of policy becomes increasingly clear.