Portfolio Manager Q&A - Bill Ford

With interest rates remaining high, and the Fed committed to reaching their inflation goal, Bill Ford, Portfolio Manager and Credit Analyst on the Reinhart Fixed Income team, shares his view on the current state of the bond market. Bill dives into where he is finding opportunities, and when he thinks interest rate hikes will start stressing corporate balance sheets.

With the 10-year Treasury now yielding above 4.2%, what does this bellwether metric tell us about the state of the economy and interest rates, and how high could it go?

Over the past month, it’s been interesting to see how much of the movement higher in rates has been in the longer end of the yield curve rather than the short end. As you start moving further and further out the yield curve, especially out towards ten years, you’re looking at longer-term market expectations about where the Fed will ultimately land in terms of the neutral interest rate, as opposed to the shorter part of the yield curve, where investors are trying to guess what the Fed will do with rates in the next year or so. The long-term neutral rate is tied to longer-term expectations for inflation and, ultimately, the longer-term premium that investors will demand for holding a bond for a longer period of time.

And that can be impacted by any number of things. For one, the fiscal policy picture has come into play much more, prompted by the recent downgrade of the U.S. government’s credit rating. So, over the past few months, this and other factors have pushed up the longer end of the yield curve, which is still inverted but not as extremely inverted as earlier this year.

As far as how high it could go, I think the big question is, has the Fed done everything it needs to do, and now we sit back and let it take effect? Or is this just a pause, and the Fed will have to re-accelerate? In the latter case, investors could expect to see the 10-year rise significantly. At its current level, we think the 10-year is fairly valued.

Did Chairman Powell’s comments at Jackson Hole provide any sense of clarity about their path to get inflation back to 2%?

The most clarity Chairman Powell provided, and I think this was very intentional on his part, was that he wanted to be clear that 2% is the goal and the Fed is committed to bringing inflation back to that level. Despite the recent chatter that maybe they should move the goal to 3% or allow inflation to run hotter, the FOMC seems unanimous in dismissing that chatter. I think this makes sense because the FOMC must maintain credibility about preserving the dollar’s value, purchasing power, and price stability.

That said, I think the Fed is legitimately becoming data dependent on a meeting-to-meeting basis, and there is likely a lot more dispersion of opinions among the FOMC members at this point in terms of the appropriate action at the next meeting, and how much further rates need to go. From our point of view, the best we can really say is that the Fed is clearly much closer to the end of the tightening cycle than the beginning. And so, given that, the question is shifting from how fast and how high rates will rise to how long rates will stay elevated.

Monetary policy tends to work on a lag of 12 to 18 months. We’re now 17 months since the first interest rate hike. When, if at all, do you think the lag effects will start to put stress on corporate balance sheets?

There is a lot of debate on the lag effects of monetary policy. And there are many different channels and mechanisms through which monetary policy works – they all work on their own timeframe. I think the most significant thing we have seen in the data so far is that the broader U.S. economy and labor market have held up surprisingly well, given the amount of tightening that has occurred already. And, it does not show signs of turning over yet, though it has decelerated some.

Where I think we will start to see the biggest impact is that after years and years of essentially free money and very, very low interest rates on debt, you have many companies that have been levered up a lot. Whether it was their own decisions for what they thought would help their stock price or whether it’s a result of private equity-type investments that tend to rely on leverage and financial engineering, what we are starting to see is a lot of very highly-levered companies that are beginning to feel the pinch of refinancing at higher interest rates. And all of a sudden, their cash flows are starting to struggle to keep up with interest rates and keep them in a position of strong financial flexibility.

When you look at the higher quality companies, a lot of the investment grade, and especially the much higher quality end of investment grade, where the Reinhart team tends to focus, we’re not seeing anybody get dinged up too badly by this yet. These higher-quality companies tend to have very high interest rate coverage multiples, so rates coming up a lot do not stress their ability to service debt.

How is your team positioning portfolios right now, given the significant inversion at the front end of the yield curve, and where are you finding opportunities in this market environment?

As we’ve discussed, the Fed is likely closer to the end of the tightening cycle than the beginning, but there remains uncertainty about how long they’ll stay at the current interest rate level. So, there is probably a lot more room for the short end of the yield curve to come down than to move up, which makes it attractive for investors. But, at the same time, if you wait to move out further on the curve, you may miss out on locking in a higher yield for a longer period of time, even if it means giving up yield.

We believe it is a good time to be neutral to slightly long on duration overall. For Reinhart, that means maybe 105% to 110% of the benchmark. We’ve moved our exposure towards the middle of the curve, towards the three-to-five range, where we feel there’s enough duration on those bonds to benefit when rates come down.

From a sector perspective, we are finding opportunities in the mortgage-backed security (MBS) market with 15-year agency collateral, in which the government guarantees the principal and interest. At current yields, the reward is historically high – 80th to 90th percentile – while the risk appears to be contained. The only real risk you have is that if longer rates come down sharply and quickly enough, you could see prepayment risk.

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