Since the last edition: Bond markets settled down a bit in May, reversing some of the year-to-date losses. Long-term U.S. Treasury yields shifted slightly higher, though yields of maturities of 10 years or less moved slightly lower. Meanwhile credit spread shifts were mixed with investment grade spreads narrowing slightly while non-investment grades slightly widened from the previous month. The U.S. Federal Reserve Board (Fed) delivered on an expected 50 basis point rate increase and maintained guidance for two more 50 basis point rate increases before slowing the rate increases back to 25 basis points. Economic data on consumer spending and inflation raised the prospect that the Fed may even be able to pause after the next 2 rate increases.
The yield curve widened slightly in May. Economic data appeared to support the narrative that the Fed may well achieve a soft landing while taming inflation. That said, we are still early in the tightening cycle and one month’s worth of economic data does not make a trend. We will wait for more data before adjusting our outlook and positioning. So far our duration shifts have captured the market opportunities.
The investment grade corporate bond portion of the Bloomberg U.S. Aggregate Bond Index rose 0.9% during the month due to falling rates and a slight narrowing of credit spreads. The Bloomberg U.S. High Yield Index returned 0.3%, recovering all of a 3% decline during the month. Credit spreads leapt to highs not seen in more than a year before giving back most of the increase in the last week of the month. The S&P/LSTA Leveraged Loan Index dropped 2.6% in the month as prices fell. As mentioned last month we had been seeing some caution flags for leveraged loans and it appears investors have decided to reprice for these risks. Our shift toward higher credit quality was in tune with market conditions.
Thematic Backdrop
- Interest Rate Risk: Last month we moved up our suggested duration to be equivalent to the Bloomberg U.S. Aggregate Bond Index. With inflation running higher than wage increases and more aggressive monetary tightening expected, we believe that the likelihood of slowing economic growth will put a ceiling on longer term Treasury bond yields. The main risk to this shift higher in duration is the potential supply/demand imbalance that may come from the Fed selling Treasuries to shrink its balance sheet. That said, we would be inclined to use higher rates to add to duration.
- Credit Risk: We moved to a quality bias in credit positioning a couple months ago. Financial conditions are beginning to tighten as indicated by a reluctance of banks wanting to own corporate debt and low issuance. Dealer inventories of corporate debt are very low, especially high yield as reported by the Fed. We also believe that the Fed will be successful at slowing the economy, raising the specter of default risk. While high yield credit spreads have widened, they are not reflective of a return to a more normal mid-cycle default rate.
- Fed Policy: The Fed has now raised the Federal Funds rate by 75 basis points, and plans to raise the rate by another 50 basis points at each of the next two meetings. The Fed will also begin reducing the size of its balance sheet on June 1. The Fed faces a difficult landscape with both demand and supply side inflation drivers. The risk of making a mistake by being either too aggressive or too lenient remains high.
- Economic Growth & Inflation: Consensus expectations for real U.S. GDP growth continue to fall. The consensus is currently at 2.7% for 2022 according to Bloomberg. This is down from expectations of 4% growth at the start of the year and 3.2% just a month ago. Forecasting is more art than science, but we believe that we may be near the end of the downward trend in forecasts. Of more concern is 2023 where the Fed is hoping to deliver a soft landing. History does not provide much support for this hope as they typically overtighten. The Fed believes a financially healthy consumer coupled with the unwinding of some transitory inflation pressures will help them achieve their objective. While that may be true, they will still be slowing the economy which provides a backdrop that is more conducive for higher quality assets.
Recent Trends
The Yield Curve held at low levels. The flat yield curve is indicative of much slower economic growth. We measure the yield curve by taking the difference between the 10 year Treasury yield and the 2 year Treasury yield, though other combinations of long and short maturities can be used. Should the 10 year to 2 year Treasury yield curve invert, history suggests that a recession is likely to follow in about 19 months (on average). An inversion is not definitive as it has produced false signals and we question whether we would have had a recession post the 2019 inversion without the pandemic, but it is an important signal that we take seriously.
Credit Spreads moved slightly higher in May though still remain relatively narrow in a historical context. Higher credit spreads (the additional yield over duration equivalent Treasury securities) is what we are looking for to shift back down in credit quality. Spreads for investment grade bonds look more attractive in a historical context than non-investment grade bonds. Non-investment grade bond yields do not even reflect an economic soft landing. Much higher credit spreads and/or evidence that the Fed won’t need to be as aggressive could entice us to move back down in credit quality.
Absolute Yields for credit exposed securities have moved higher. The yield for the Bloomberg U.S. Corporate High Yield Index closed the month near 7%. Meanwhile the yield for the Bloomberg U.S. Aggregate Bond Index was 3.4% and 4.2% for investment grade corporate bonds. With the exception of a brief period at the end of 2018 this is the highest yield seen for investment grade bonds in over a decade. The greater safety of the investment grade indexes and now higher absolute yield is making them look more attractive with a backdrop of slowing economic growth and a Fed that is willing to sacrifice economic growth to tame inflation.
Risks/Opportunities
We believe the biggest investment risk in fixed income today is related to real returns. With interest rates still fairly low and inflation expected to remain above the Fed’s 2% target for some time, investors are likely to struggle to maintain spending power through their fixed income allocation. Related to this risk is the potential likelihood that the Fed slows the economy which could create headwinds for more economically sensitive credit securities. From an opportunity standpoint, investment grade yields have moved up while economic growth and inflation are expected to slow later this year. After a brutal start to the year it may be time to consider adding to both duration and quality.
Positioning Considerations
- With few exceptions fixed income securities have had one of the worst starts to a year in decades. Uncertainty still prevails given cross currents of pandemic recovery, war in Ukraine, high inflation, expected monetary policy tightening, and slowing economic growth. Yet we believe parts of the fixed income marketplace have adjusted (painfully) to these less promising conditions, namely within the investment grade universe. With heightened risks of a more aggressive Fed, a profit margin squeeze from tight labor conditions, or an economy that may slow at a more rapid rate than expected, fixed income may provide ballast to a portfolio given higher current interest rates. We believe that investors should consider a more active and flexible strategy that could take advantage of mispriced sectors and rapidly changing market conditions.
- For those investors concerned about either rising inflation or rising interest rates we suggest considering strategies that have a lower than benchmark duration. That said, should inflation and economic growth slow, current long-term interest rates may outperform the very short end of the curve. Additionally, through an active strategy one may be able to access bond categories that sit outside of the Bloomberg U.S. Aggregate Bond Index that are investment grade, yet carry more attractive yields.
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Looking around the corner. Visibility is low as we don’t know how aggressive the Fed’s stimulus removal will be, or at what rate of growth the economy will settle. The war in Ukraine further complicates the outlook. Here are a few considerations.
- In his latest Congressional testimony Fed Chair Jerome Powell suggested that the Fed is willing to sacrifice economic growth to tame inflation. Economic theory suggests that for the Fed to slow inflation they would need to get real GDP growth below potential. Potential real GDP growth is believed to be around 2%. How high the Fed will need to raise short-term rates to achieve this is unknown, but we believe it is safe to suggest they are going higher. We believe a significant rise in short-term rates is likely to create fear of even slower economic growth which would push investors out the maturity curve and away from non-investment grade bonds.
- Due to the unique nature of the pandemic and the very aggressive fiscal and monetary response to it, this cycle has been and will continue to be unique. While we are moving toward a more cautious stance within fixed income, we also need to be prepared for a possible swing in the other direction. Should the rate of inflation moderate at a more rapid rate than expected, then the Fed would be able to slow the pace of tightening. This would re-open the door to a possible soft landing for the economy, the potential for an extended cycle, and a less cautious stance within fixed income.
- In his latest Congressional testimony Fed Chair Jerome Powell suggested that the Fed is willing to sacrifice economic growth to tame inflation. Economic theory suggests that for the Fed to slow inflation they would need to get real GDP growth below potential. Potential real GDP growth is believed to be around 2%. How high the Fed will need to raise short-term rates to achieve this is unknown, but we believe it is safe to suggest they are going higher. We believe a significant rise in short-term rates is likely to create fear of even slower economic growth which would push investors out the maturity curve and away from non-investment grade bonds.
Fixed Income Indexes Characteristics
The Indexes mentioned are unmanaged statistical composites of stock market or bond market performance. Investing in an index is not possible.
| Total Returns |
|---|
| May 2022 | YTD | 2021 | 2020 | 2019 | Duration Years | |
|---|---|---|---|---|---|---|
| Bloomberg Long Term Treasury | -1.9% | -20.1% | -4.6% | 13.6% | 11.0% | 17.4 |
| Bloomberg U.S. TIPS |
-1.0% | -5.9% | 6.0% | 11.0% | 8.4% | 7.3 |
| Bloomberg U.S. Aggregate | 0.6% | -8.9% | -1.5% | 7.5% | 8.7% | 6.7 |
| Bloomberg U.S. Agg Corporates | 0.9% | -11.9% | -1.0% | 9.9% | 14.5% | 7.9 |
| Bloomberg U.S. Agg ABS | 0.3% | -3.3% | -0.3% | 4.5% | 4.5% | 2.3 |
| Bloomberg U.S. Agg MBS |
1.1% | -7.3% | -1.0% | 3.9% | 6.4% | 6.1 |
| Bloomberg U.S. Agg CMBS |
0.2% | -7.6% | -0.9% | 8.1% | 8.3% | 4.9 |
| Bloomberg Municipal Bond |
1.5% | -7.5% | 1.5% | 5.2% | 7.5% | 5.3 |
| Bloomberg 1-3 year Corporate |
0.7% | -2.5% | -0.1% | 1.3% | 2.7% | 2.0 |
| ICE BofA Listed Preferreds |
2.6% | -10.2% | 7.7% | 8.6% | 18.5% | NA |
| Bloomberg High Yield |
0.2% | -8.0% | 5.3% | 7.1% | 14.3% | 4.7 |
| S&P/LSTA Leveraged Loan |
-2.6% | -2.4% | 5.2% | 3.1% | 8.6% | NA |
| Bloomberg Global Agg |
0.3% | -11.1% | -4.7% | 9.2% | 6.8% | 7.2 |
| Bloomberg Emerging Markets USD |
0.0% | -13.2% | -1.7% | 6.5% | 13.1% | 6.7 |
| Yields |
|---|
| May 2022 | YTD Change bps | Current Percentile | 10 YR Median | 10 YR Min | 10 YR Max | |
|---|---|---|---|---|---|---|
| 10 year Treasury |
2.8% | 133 | 91 | 2.1% | 0.5% | 3.2% |
| 2 year Treasury | 2.6% | 182 | 95 | 0.7% | 0.1% | 3.0% |
| 10 year TIPS | 0.2% | 130 | 45 | 0.3% | -1.2% | 1.2% |
| Bloomberg U.S. Aggregate | 3.4% | 162 | 96 | 2.3% | 1.0% | 3.7% |
| Bloomberg U.S. Agg Corporate |
4.2% | 188 | 97 | 3.1% | 1.7% | 4.6% |
| Bloomberg U.S. Agg ABS | 3.4% | 224 | 100 | 1.5% | 0.4% | 3.6% |
| Bloomberg U.S. Agg MBS | 3.5% | 148 | 95 | 2.6% | 0.9% | 3.8% |
| Bloomberg U.S. Agg CMBS | 3.9% | 194 | 100 | 2.4% | 1.4% | 4.0% |
| Bloomberg Municipal Bond |
2.9% | 181 | 92 | 2.2% | 0.9% | 3.5% |
| Bloomberg High Yield |
7.1% | 288 | 85 | 6.0% | 3.5% | 11.7% |
| S&P/LSTA Leveraged Loan |
5.8% | 188 | 77 | 5.2% | 3.6% | 13.1% |
| Bloomberg Global Agg |
2.6% | 128 | 100 | 1.7% | 0.8% | 2.7% |
| Bloomberg Emerging Markets USD |
6.3% | 201 | 98 | 4.9% | 3.5% | 7.9% |
| Option Adjusted Spreads (bps) |
|---|
| May 2022 |
YTD Change | Current Percentile | 10 YR Median | 10 YR Min | 10 YR Max | |
|---|---|---|---|---|---|---|
| Bloomberg U.S. Corporate Agg |
129 | 37 | 60 | 122 | 80 | 373 |
| Bloomberg 1-3 year Corporate | 71 | 30 | 58 | 66 | 31 | 390 |
| Bloomberg U.S. Agg ABS | 85 | 47 | 98 | 48 | 22 | 325 |
| Bloomberg U.S. Agg MBS | 34 | 2 | 57 | 31 | 7 | 132 |
| Bloomberg U.S. Agg CMBS | 109 | 34 | 65 | 95 | 62 | 275 |
| Bloomberg High Yield | 402 | 119 | 51 | 404 | 262 | 1100 |
| Bloomberg Emerging Markets USD | 354 | 34 | 77 | 310 | 211 | 720 |
For Index Definitions see: TouchstoneInvestments.com/insights/investment-terms-and-index-definitions
2019 – The Fed stopped tightening and then began to ease. Everything rallied, recession risk diminished and rates moved down (likely due to US/China trade war risk and foreign buying).
2020 – Pandemic. Fed in massive stimulus mode. Interest rates dropped precipitously. Credit rallied after Fed started buying junk bonds and fiscal stimulus measures appeared to be more than enough to offset economic downturn.
2021 – Pandemic continued in waves. Fed held rates near zero and continued to grow its balance sheet at a moderate pace. Long duration bonds sold off while Treasury Inflation Protected Securities rallied on inflation concerns. Exclusive of duration credit exposed securities generally earned their yield.
A Word About Risk
Investing in fixed-income securities which can experience reduced liquidity during certain market events, lose their value as interest rates rise and are subject to credit risk which is the risk of deterioration in the financial condition of an issuer and/or general economic conditions that can cause the issuer to not make timely payments of principal and interest also causing the securities to decline in value and an investor can lose principal. When interest rates rise, the price of debt securities generally falls. Longer term securities are generally more volatile. Investment grade debt securities which may be downgraded by a Nationally Recognized Statistical Rating Organization (NRSRO) to below investment grade status. U.S. government agency securities which are neither issued nor guaranteed by the U.S. Treasury and are not guaranteed against price movements due to changing interest rates. Mortgage-backed securities and asset-backed securities are subject to the risks of prepayment, defaults, changing interest rates and at times, the financial condition of the issuer. Foreign securities carry the associated risks of economic and political instability, market liquidity, currency volatility and accounting standards that differ from those of U.S. markets and may offer less protection to investors. Emerging markets securities which are more likely to experience turmoil or rapid changes in market or economic conditions than developed countries.
Performance data quoted represents past performance, which is no guarantee of future results. The investment return and principal value of an investment in the Fund will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original cost. Current performance may be higher or lower than performance data given. For performance information current to the most recent month-end, visit TouchstoneInvestments.com/mutual-funds.
Please consider the investment objectives, risks, charges and expenses of the fund carefully before investing. The prospectus and the summary prospectus contain this and other information about the Fund. To obtain a prospectus or a summary prospectus, contact your financial professional or download and/or request one on the resources section or call Touchstone at 800-638-8194. Please read the prospectus and/or summary prospectus carefully before investing.
Touchstone Funds are distributed by Touchstone Securities, Inc.*
*A registered broker-dealer and member FINRA/SIPC.
Touchstone is a member of Western & Southern Financial Group
Not FDIC Insured | No Bank Guarantee | May Lose Value
