• Following recent bond market volatility which saw the 10yr UST yield re-test its October high, the Bloomberg Agg total return is up only 64bps year-to-date.
• We believe this yield volatility is technically driven and our base case for lower bond yields remains in place
• We remain well positioned for both our base case and most likely alternative scenarios

After years of very low yields, in March of 2022, the Federal Reserve, fighting inflation, embarked on a very rapid rate hiking program, moving the Fed Funds rate from nearly zero to over 4% in just nine months. During this period, yields on longer maturity Treasuries also rose dramatically with the 10yr UST yield starting below 2% at the beginning of 2022 and, by late October, hitting an intraday high above 4.30%. This yield marked the highest level in 15 years, providing what some called “a generational opportunity to add duration”.

After a tumultuous 2022, bond investors entered 2023 looking forward to strong fixed income returns. Many expected this would be the year “bonds are back”. That bonds would return to their traditional role of providing a source of income and portfolio diversification.

Our investing thesis entering the year was that such a large and rapid rise in interest rates would ultimately result in a recession and create problems for weaker credits, eventually forcing the Federal Reserve to cut rates at some point. We knew that given the long and variable effects of monetary policy, it could take time for this to play out and rates could rise further in the short term. Still, even if the Fed were to proceed with a few more hikes, our expectation was that we had likely experienced the bulk of the move already and, given that it is always difficult to pick a top, this was a good time to start adding duration and being cautious on risk exposure.

In the first half of 2023, the 10yr traded in a range of 3.25% - 4%, even while inflation remained “sticky”, causing the Fed to push the funds rate a further 100bps to its current level of 5.25% - 5.50%. In the spring, we saw several high-profile regional bank failures and it appeared cracks in the economy were emerging and inflation began to show clearer signs of easing. However, labor markets remained strong and, following aggressive reactions by the regulators on the regional banks, investors began talking more about a possible soft landing.  We note that historically, when the Fed is done hiking, it often appears initially they have engineered a “soft landing” for some period. 2000-2001 and 2006-2007 are examples of cycles that were initially viewed with “soft landing” optimism though these were clearly “hard landings” in hindsight.

As of August 2023, the soft landing and higher-for-longer rates narrative has grown, and it appears bond buyers are on vacation. This, coupled with higher issuance from Treasury in the last few weeks, caused 10yr UST yields to re-test last October’s highs.

As a result, the year-to-date total return of the broad fixed income market, as represented by the Bloomberg US Aggregate Index, is only 64bps as of 8/23. While meager, higher starting yields (a larger income cushion) has softened the blow of the retracement higher in long dated Treasury rates. However, it is reasonable to ask why returns from fixed income haven’t been higher and if there is risk of a further bond sell-off. 

While painful, bear steepening episodes (where yields on longer maturities rise more than yields on shorter maturities) in the Treasury market, like the one we experienced in the middle of August, have been historically short-lived and uncommon. Bear steepening at the end of a rate hiking cycle should eventually morph into a more sustainable bull steepening move. 

With clear signs that inflation is now easing, and indications that growth is slowing, we believe the Federal Reserve likely finished hiking for this cycle in July and will eventually cut -- though this may take longer than investors had originally expected. 

While there is always a risk that yields rise further, we believe the current dynamics are primarily driven by technical factors and that yields are higher than fundamentally justified. As a result, we believe the current bond sell-off provides an attractive risk / reward tradeoff with real yields now at multi-decade highs. That said, it will be a few weeks before the technical picture eases and rates could still drift higher in the near-term.

Keep in mind that higher yields are, in a way, self-healing as they are a good indicator of future returns and higher yields provide more cushion for investors to be patient while waiting for the market to refocus on fundamentals. 

Let’s consider three possible scenarios:

First, inflation continues showing signs of easing, the labor market begins to soften, problems grow in weaker credits and perhaps certain real estate segments or regional banks. The market begins to price in a recession and ultimately the Federal Reserve cuts the funds rate. This should lead to a bull steepening with lower overall Treasury rates and a risk-off move in credit. This is the base case for which we are positioned.

Second, we get the soft landing. In this scenario, inflation continues to slow without labor market weakness and rates drift lower but more slowly. Still a positive for rates and bond funds in general. 

Third, inflation re-ignites, forcing the Fed to raise the funds rate to 6% by year-end and the 10yr rises to 5.25%. We have considered this stress scenario and are comfortable that while intermediate duration, high quality portfolios would likely experience somewhat negative returns, the high carry helps to keep losses to manageable.

Unless we see a clear reacceleration in inflation, we continue to use backups in yield as an opportunity to add duration. We also continue to stress every holding in our portfolio for recession and rotate into more recession resilient issuers.  

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